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DSS, INC. - Quarter Report: 2008 September (Form 10-Q)

Unassociated Document

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2008
 
1-32146

Commission file number


DOCUMENT SECURITY SYSTEMS, INC.
(Exact name of registrant as specified in its charter)

New York
 
16-1229730
(State of incorporation)
 
(IRS Employer Identification Number)

28 Main Street East, Suite 1525
Rochester, NY 14614
(Address of principal executive office)

(585) 325-3610
(Registrant's telephone number)

Indicate by check mark whether the registrant:
(1) filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the preceding 12 months (or for such shorter period that the registrant was required to file such reports)

And
(2) has been subject to such filing requirements for the past 90 days.
Yes x  No ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definition of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer ¨ Accelerated filer x Non-accelerated filer ¨ Smaller reporting company ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act)
Yes ¨  No x
 
Applicable only to corporate issuers
As of November 7, 2008 (the most recent practicable date), there were 14,472,994 shares of the issuer's Common Stock, $0.02 par value per share, outstanding.



DOCUMENT SECURITY SYSTEMS, INC.
FORM 10-Q
TABLE OF CONTENTS

PART I
 
FINANCIAL INFORMATION
 
   
Item 1
 
Financial Statements
 
 
 
 
Consolidated Balance Sheets
 
3
 
 
Consolidated Statements of Operations
 
4
 
 
Consolidated Statements of Cash Flows
 
5
 
 
Notes to Interim Consolidated Financial Statements
 
6
Item 2
 
Management's Discussion and Analysis of Financial Condition and Results of Operations
 
16
Item 3
 
Quantitative and Qualitative Disclosures about Market Risk
 
23
Item 4
 
Controls and Procedures
 
23
  
      
 
PART II
 
OTHER INFORMATION
 
 
Item 1
 
Legal Proceedings
 
23
Item 1a
 
Risk Factors
 
25
Item 2
 
Unregistered Sales of Equity Securities and Use of Proceeds
 
30
Item 3
 
Defaults upon Senior Securities
 
30
Item 4
 
Submission of Matters to a Vote of Security Holders
 
30
Item 5
 
Other Information
 
30
Item 6
 
Exhibits
 
31
 
     
 
SIGNATURES 

2

 
PART I
 
FINANCIAL INFORMATION
ITEM 1 - FINANCIAL STATEMENTS 

DOCUMENT SECURITY SYSTEMS, INC.  AND SUBSIDIARIES
Consolidated Balance Sheets
As of

     
September 30,
 
December 31,
 
     
2008
 
2007
 
   
(unaudited)
 
(audited)
 
ASSETS
           
             
Current assets:
           
Cash and cash equivalents
 
$
442,803
 
$
742,468
 
Restricted cash
   
157,500
   
-
 
Accounts receivable, net of allowance of $65,000 ($82,000 as of December 31, 2007)
   
784,668
   
617,320
 
Inventory
   
230,272
   
259,442
 
Loans to employees
   
67,781
   
120,732
 
Prepaid expenses and other current assets
   
87,906
   
487,715
 
               
Total current assets
   
1,770,930
   
2,227,677
 
               
Restricted cash
   
-
   
177,345
 
Fixed assets, net
   
1,349,230
   
1,494,540
 
Other assets
   
258,085
   
147,958
 
Goodwill
   
1,396,734
   
1,396,734
 
Other intangible assets, net
   
3,580,285
   
6,149,530
 
               
Total assets
 
$
8,355,264
 
$
11,593,784
 
               
LIABILITIES AND STOCKHOLDERS' EQUITY
             
               
Current liabilities:
             
Accounts payable
 
$
1,353,926
 
$
1,795,085
 
Accrued expenses & other current liabilities
   
1,112,404
   
818,606
 
Deferred revenue & customer deposits
   
56,580
   
732,355
 
Current portion of capital lease obligations
   
84,129
   
79,948
 
               
Total current liabilities
   
2,607,039
   
3,425,994
 
               
Revolving notes from related parties
   
1,858,000
   
300,000
 
Capital lease obligations
   
215,229
   
294,821
 
Deferred revenue
   
-
   
15,938
 
Deferred tax liability
   
203,397
   
200,000
 
               
Commitments and contingencies (see Note 10)
             
               
Stockholders' equity
             
Common stock, $.02 par value; 200,000,000 shares authorized, 14,359,756 shares issued and outstanding (13,654,364 in 2007) (325,000 subscribed in 2008)
   
287,195
   
273,087
 
Additional paid-in capital
   
34,881,064
   
31,298,571
 
Subscriptions receivable
   
(1,300,000
)
 
-
 
Accumulated deficit
   
(30,396,660
)
 
(24,214,627
)
Total stockholders' equity
   
3,471,599
   
7,357,031
 
Total liabilities and stockholders' equity
 
$
8,355,264
 
$
11,593,784
 

See accompanying notes

3

 
DOCUMENT SECURITY SYSTEMS, INC. AND SUBSIDIARIES
Consolidated Statements of Operations
(unaudited)

    
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
   
2008
 
2007
 
2008
 
2007
 
Revenue
                 
Security printing and products
 
$
1,334,184
 
$
945,941
 
$
3,421,437
 
$
2,764,323
 
Royalties
   
181,047
   
278,290
   
1,401,522
   
871,243
 
Digital solutions
   
8,220
   
9,469
   
24,660
   
184,240
 
Legal products
   
150,129
   
175,725
   
482,561
   
513,070
 
Total Revenue
   
1,673,580
   
1,409,425
   
5,330,180
   
4,332,876
 
Costs of revenue
                         
Security printing and products
   
635,934
   
635,935
   
2,027,636
   
1,691,473
 
Digital solutions
   
3,507
   
3,507
   
10,521
   
40,521
 
Legal products
   
86,120
   
82,575
   
257,536
   
276,342
 
Total costs of revenue
   
725,561
   
722,017
   
2,295,693
   
2,008,336
 
                           
Gross profit
   
948,019
   
687,408
   
3,034,487
   
2,324,540
 
                           
Operating expenses:
                         
Selling, general and administrative
   
1,789,790
   
1,979,171
   
5,828,136
   
5,587,903
 
Research and development
   
72,876
   
110,833
   
322,106
   
314,130
 
Impairment of patent defense costs
   
-
   
-
   
291,581
   
-
 
Amortization of intangibles
   
540,934
   
480,256
   
1,605,104
   
1,258,985
 
Operating expenses
   
2,403,600
   
2,570,260
   
8,046,927
   
7,161,018
 
                           
Operating loss
   
(1,455,581
)
 
(1,882,852
)
 
(5,012,440
)
 
(4,836,478
)
                           
Other income (expense):
                         
Interest income
   
484
   
14,829
   
569
   
89,816
 
Gain (loss) on foreign currency transactions
   
7,534
   
(6,378
)
 
(16,652
)
 
(10,669
)
Interest expense
   
(41,208
)
 
(1,362
)
 
(95,098
)
 
(3,811
)
Loss on sale of patent assets
   
(1,169,947
)
 
-
   
(1,169,947
)
 
-
 
Other Income
   
-
   
-
   
125,795
   
-
 
                           
Loss from continuing operations before income taxes
   
(2,658,718
)
 
(1,875,763
)
 
(6,167,773
)
 
(4,761,142
)
                           
Income tax expense
   
4,738
   
4,738
   
14,260
   
14,214
 
                           
Loss from continuing operations
   
(2,663,456
)
 
(1,880,501
)
 
(6,182,033
)
 
(4,775,356
)
                           
Loss from discontinued operations (Note 8)
                         
Gain on sale of discontinued assets
         
42,905
         
42,905
 
Loss from discontinued operations
   
-
   
(43,807
)
 
-
   
(59,233
)
Loss on discontinued operations
   
-
   
(902
)
 
-
   
(16,328
)
                           
Net loss
 
$
(2,663,456
)
$
(1,881,403
)
$
(6,182,033
)
$
(4,791,684
)
                           
Net loss per share -basic and diluted:
                         
Continuing operations
 
$
(0.19
)
$
(0.14
)
$
(0.45
)
$
(0.35
)
Discontinued operations
   
(0.00
)
 
0.00
   
(0.00
)
 
0.00
 
Net Loss
 
$
(0.19
)
$
(0.14
)
$
(0.45
)
$
(0.35
)
Weighted average common shares outstanding, basic and diluted
   
14,286,192
   
13,676,030
   
13,879,891
   
13,629,241
 
 
See accompanying notes

4


DOCUMENT SECURITY SYSTEMS, INC. AND SUBSIDIARIES
Consolidated Statements of Cash Flows
For the Nine Months Ended September 30,
(unaudited)
 
   
2008
 
2007
 
Cash flows from operating activities:
         
Net loss
 
$
(6,182,033
)
$
(4,791,684
)
               
Adjustments to reconcile net loss to net cash used by operating activities:
             
Depreciation and amortization
   
1,841,975
   
1,396,262
 
Stock based compensation
   
1,536,403
   
970,829
 
Impairment of patent defense costs
   
291,581
   
-
 
Net gain on disposal of discontinued operations
   
-
   
(42,905
)
Loss on sale of patent assets
   
1,169,947
   
-
 
Decrease in restricted cash
   
19,845
   
-
 
(Increase) decrease in assets:
             
Accounts receivable
   
(167,348
)
 
(112,870
)
Inventory
   
29,170
   
4,762
 
Prepaid expenses and other assets
   
(43,049
)
 
(171,526
)
Increase (decrease) in liabilities:
             
Accounts payable
   
(65,053
)
 
445,334
 
Accrued expenses and other liabilities
   
143,914
   
(25,635
)
Deferred revenue
   
(691,713
)
 
(234,464
)
Net cash used by operating activities
   
(2,116,361
)
 
(2,561,897
)
               
Cash flows from investing activities:
             
Purchase of fixed assets
   
(226,716
)
 
(423,918
)
Proceeds from the sale of discontinued operations
   
-
   
80,000
 
Proceeds from the sale of patent assets
   
500,000
   
-
 
Purchase of other intangible assets
   
(1,144,351
)
 
(1,150,977
)
Net cash used by investing activities
   
(871,067
)
 
(1,494,895
)
               
Cash flows from financing activities:
             
Borrowing on short-term credit facility
   
500,000
   
-
 
Repayment on short-term credit facility
   
(500,000
)
 
-
 
Borrowing on revolving note- related parties
   
1,558,000
   
-
 
Repayments of capital lease obligations
   
(75,411
)
 
(27,140
)
Increase in restricted cash
   
-
   
(177,345
)
Payment of stock issuance costs
   
-
   
(519,619
)
Issuance of common stock
   
1,205,174
   
355,225
 
Net cash provided (used) by financing activities
   
2,687,763
   
(368,879
)
     
   
 
Net increase (decrease) in cash and cash equivalents
   
(299,665
)
 
(4,425,671
)
Cash and cash equivalents beginning of period
   
742,468
   
5,802,615
 
Cash and cash equivalents end of period
 
$
442,803
 
$
1,376,944
 

See accompanying notes.
 
5

 
DOCUMENT SECURITY SYSTEMS, INC.
NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2008
(Unaudited)
 
1.     Basis of Presentation and Significant Accounting Policies
 
The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, these statements do not include all of the information and footnotes required by U.S. generally accepted accounting principles for complete financial statements. In the opinion of management, the accompanying balance sheets and related interim statements of operations and cash flows include all adjustments, consisting only of normal recurring items necessary for their fair presentation in accordance with U.S. generally accepted accounting principles. All significant intercompany transactions have been eliminated.

Interim results are not necessarily indicative of results expected for a full year. For further information regarding Document Security Systems, Inc (the “Company”) accounting policies, refer to the audited consolidated financial statements and footnotes thereto included in the Company's Form 10-K for the fiscal year ended December 31, 2007.

The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ materially from those estimates and assumptions.

Other Intangible AssetsOther intangible assets consists of costs associated with the application, acquisition and defense of the Company’s patents, contractual rights to patents and trade secrets associated with the Company’s technologies, a non-exclusive licensing agreement, and customer lists obtained as a result of acquisitions. The Company’s patents and trade secrets are for document anti-counterfeiting and anti-scanning technologies and processes that form the basis of the Company’s document security business. External legal costs incurred to defend the Company’s patents are capitalized to the extent of an evident increase in the value of the patents and an expected successful outcome. Legal costs are expensed at the point when it is determined that the outcome is expected to be unsuccessful. The Company capitalizes the cost of an appeal until it is determined that the appeal will be unsuccessful. The Company’s capitalized patent defense costs expenses are analyzed for impairment based on the expected eventual outcome of the legal action and recoverability of proceeds or added economic value of the patent in excess of the costs. Legal actions related to the same patent defense case are unified into one asset group for the purposes on the impairment analysis. The Company amortizes its other intangible assets over their estimated useful lives. Patents are amortized over the remaining legal life, up to 20 years. Intangible asset amortization expense is classified as an operating expense.

Recent Accounting Pronouncements In September 2006, the FASB issued SFAS No.157, Fair Value Measurements. SFAS No. 157, as amended, defines fair value, establishes a framework for measuring fair value in accordance with accounting principles generally accepted in the United States of America, and expands disclosures about fair value measurements. With respect to financial assets and liabilities, SFAS No. 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007. However, in February 2008, the FASB determined that an entity need not apply this standard to nonfinancial assets and liabilities that are recognized or disclosed at fair value in the financial statements on a nonrecurring basis until 2009. Accordingly, the Company’s adoption of this standard on January 1, 2008, is limited to financial assets and liabilities and did not have a material effect on the Company’s financial condition or results of operations. The Company’s still in the process of evaluating the impact of this standard with respect to its effect on nonfinancial assets and liabilities and has not yet determined the impact that it will have on the consolidated financial statements upon full adoption.

In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities, which permits entities to choose to measure certain financial assets and liabilities at fair value. SFAS No. 159 is effective for years beginning after November 15, 2007. The Company has not adopted the fair value option method permitted by SFAS No. 159.
 
6

 
In December 2007, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 141 (revised 2007), “Business Combinations” (“SFAS 141R”), which replaces SFAS 141. SFAS 141R establishes principles and requirements for how an acquirer in a business combination recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, and any controlling interest; recognizes and measures the goodwill acquired in the business combination or a gain from a bargain purchase; and determines what information to disclose to enable users of the financial statements to evaluate the nature and financial effects of the business combination. SFAS 141R is to be applied prospectively to business combinations for which the acquisition date is on or after an entity’s fiscal year that begins after December 15, 2008. We are currently evaluating the potential impact of the adoption of SFAS 141R on our consolidated financial position, results of operations and cash flows.

In December 2007, the FASB issued SFAS No. 160, Noncontrolling Interests in Consolidated Financial Statements-on Amendment of ARB No. 51. SFAS No. 160 establishes accounting and reporting standards for the noncontrolling interest in a subsidiary. SFAS No. 160 is effective for financial statements issued for fiscal years beginning after December 15, 2008, and interim statements within those fiscal years. Among other things, SFAS No. 160 requires noncontrolling interest to be included as a component of shareholders’ equity. The Company does not currently have any noncontrolling interests.

On December 21, 2007, the SEC issued Staff Accounting Bulletin No. 110, “Share-Based Payment”. SAB No. 110 addresses the use of a “simplified” method in developing an estimate of expected term of “plain vanilla” share options in accordance SFAS No. 123(R), “Share-Based Payment”. SAB No. 110 allows the use of the “simplified” method of estimating expected term where a company may not have sufficient historical exercise data. SAB No. 110 is effective January 1, 2008 and the Company plans to continue to use the simplified method to estimate the expected term of its plain vanilla employee options.  
 
On December 12, 2007, the Financial Accounting Standards Board (FASB) ratified the Emerging Issues Task Force (“EITF”) opinion related to EITF Issue 07-1, “Accounting for Collaborative Arrangements.” The Task Force reached a consensus that a collaborative arrangement is a contractual arrangement that involves two or more parties, all of which are both (a) involved as active participants in a joint operating activity that is not conducted primarily through a separate legal entity and (b) exposed to significant risks and rewards that depend on the commercial success of the joint operating activity. This Issue also addresses (i) the income statement classification by participants in a collaborative arrangement for transactions with third parties and transactions between the participants and (ii) financial statement disclosures. The consensus on EITF Issue 07-1 is effective for fiscal years beginning after December 15, 2008, and for interim periods within those fiscal years. Entities should apply the consensus retrospectively to all periods presented for only those collaborative arrangements existing as of the effective date, unless it is impractical to do so. The Company will adopt this new accounting pronouncement effective January 1, 2009, and does not anticipate any material impact on its financial condition or results of operations.

In April 2008, the FASB issued FSP FAS 142-3, “Determination of Useful Life of Intangible Assets” (“FSP FAS 142-3”). FSP FAS 142-3 amends the factors that should be considered in developing the renewal or extension assumptions used to determine the useful life of a recognized intangible asset under FAS 142, “Goodwill and Other Intangible Assets.” FSP FAS 142-3 also requires expanded disclosure related to the determination of intangible asset useful lives. FSP FAS 142-3 is effective for fiscal years beginning after December 15, 2008. The Company is currently evaluating the potential impact the adoption of FAS FSP 142-3 will have on its financial statements.
 
In May 2008, the FASB issued FASB Staff Position (“FSP”) APB 14-1, “Accounting for Convertible Debt Instruments That May Be Settled in Cash upon Conversion (Including Partial Cash Settlement)” (“FSP APB 14-1”), which clarifies the accounting for convertible debt instruments that may be settled in cash upon conversion, including partial cash settlement. FSP APB 14-1 specifies that an issuer of such instruments should separately account for the liability and equity components of the instruments in a manner that reflect the issuer’s non-convertible debt borrowing rate when interest costs are recognized in subsequent periods. FSP APB 14-1 is effective for fiscal years beginning after December 15, 2008, and retrospective application is required for all periods presented. The Company is currently evaluating the potential impact of the adoption of FSP APB 14-1 on its financial statements.
 
In May 2008, the FASB issued SFAS No. 162, The Hierarchy of Generally Accepted Accounting Principles. The purpose of this statement is to improve financial reporting by providing a consistent framework for determining applicable accounting principles to be used in the preparation of financial statements presented in conformity with accounting principles generally accepted in the United States of America. SFAS No. 162 will become effective 60 days after the SEC’s approval. The Company believes that the adoption of this standard on its effective date will not have a material effect on the consolidated financial statements
 
7

 
In June 2008, the FASB issued FSP EITF 03-6-1 to address whether instruments granted in share-based payment transactions are participating securities prior to their vesting and therefore need to be included in the earnings per share calculation under the two-class method described in SFAS No. 128, “Earnings per Share.” This FSP requires companies to treat unvested share-based payment awards that have non-forfeitable rights to dividends or dividend equivalents as participating securities and thus, include them in calculation of basic earnings per share. FSP EITF 03-6-1 is effective for fiscal years beginning after December 15, 2008. The Company does not anticipate a material impact on its financial statements or its computation of basic earnings per share upon adoption.
 
During the quarter ended June 30 2008, the Company adopted FSP 00-19-2, Accounting for Registration Payment Arrangements. This FSP specifies that the contingent obligation to make future payments or otherwise transfer consideration under a registration payment arrangement, whether issued as a separate agreement or included as a provision of a financial instrument or other agreement, should be separately recognized and measured in accordance with FASB Statement No. 5, Accounting for Contingencies. The Company has determined it to be remote, that it will be required to remit payments to the investors for failing to obtain an effective registration statement on or before the required time frame.
 
2.     Restricted Cash
 
In July 2007, the Company established a restricted cash balance of 87,500 British pounds, or approximately $157,500 (as of September 30, 2008), as collateral for a deed of guarantee that was required by the English Court of Appeals in order for the Company to pursue an appeal in that court. On March 19, 2008, the Company was notified that its appeal was denied and that the Company owed the European Central Bank, the successful party in the appeal, the 87,500 British pounds. On May 14, 2008, the Company made a payment of 87,500 British pounds to the European Central Bank as an interim payment of the appeal costs pending final assessment by the Court which is expected in the fourth quarter of 2008. The Company was not able to apply the funds in its restricted account to this payment. The Company will use the restricted funds to pay additional fees due upon final assessment of the costs by the Court, if any. Accordingly, the Company classified the restricted cash as current as of September 30, 2008. (See Note 10 Commitments and Contingencies)
 
3. Inventory
 
Inventory consisted of the following:
 
     
September 30
 
December 31,
 
   
2008
 
2007
 
   
(unaudited)
 
(audited)
 
           
Finished Goods
 
$
143,606
 
$
161,978
 
Raw Materials
   
86,666
   
97,464
 
               
   
$
230,272
 
$
259,442
 
 
8

 
4.     Other Intangible Assets
 
Other intangible assets are comprised of the following:

        
September 30, 2008
 
December 31, 2007
 
   
Useful
Life
 
Gross Carrying
Amount
 
Accumulated
Amortizaton
 
Net Carrying
Amount
 
Gross Carrying
Amount
 
Accumulated
Amortizaton
 
Net Carrying
Amount
 
Royalty rights
   
5 years
 
$
90,000
 
$
85,500
 
$
4,500
 
$
90,000
 
$
72,000
 
$
18,000
 
Other intangibles
   
5 years
   
1,187,595
   
508,374
 
$
679,221
   
1,187,595
   
335,304
   
852,291
 
Patent and contractual rights
   
Varied
(1) 
 
5,427,570
   
2,531,006
 
$
2,896,564
   
8,205,340
   
2,926,101
   
5,279,239
 
         
$
6,705,165
 
$
3,124,880
 
$
3,580,285
 
$
9,482,935
 
$
3,333,405
 
$
6,149,530
 
 
(1)- patent rights are amortized over their expected useful life which is generally the legal life of the patent. As of September 30, 2008 the weighted average remaining useful life of these assets in service was 3.0 years.
 
On March 19, 2008, the Company received notification that its appeal of the invalidation of its European Patent 455750B1 in the UK was not successful. As result of the adverse court decision, the Company recognized an impairment loss of approximately $292,000 associated with the U.K appeal as of March 31, 2008. The impairment loss includes a judgment for reimbursement of estimated counterpart legal fees. The Company may owe additional counter party legal fees associated with the decision, which the Company will expense as soon as the amount, if any, is estimatable.
 
On August 20, 2008, the Company entered into an agreement with Trebuchet Capital Partners, LLC (“Trebuchet”) under which Trebuchet has agreed to pay substantially all of the litigation costs associated with pending validity proceedings initiated by the European Central Bank (“ECB”) in eight European countries relating to the Company’s European Patent 0 455 750B1 that the Company has claimed the ECB infringed in printing of the Euro currency (the “Patent”). Trebuchet also agreed to pay substantially all of the litigation costs associated with future validity challenges filed by the ECB or other parties, provided that Trebuchet elects to assume the defense of any such challenges, in its sole discretion, and patent infringement suits filed against the ECB and certain other alleged infringers of the Patent, all of which suits may be brought at the sole discretion of Trebuchet and may be in the name of the Company, Trebuchet or both. The Company provided Trebuchet with the sole and exclusive right to manage infringement litigation relating to the Patent in Europe, including the right to initiate litigation in the name of the Company, Trebuchet or both and to choose whom and where to sue, subject to certain limitations set forth in the agreement. Under the terms of the Agreement, the Company and Trebuchet have agreed to equally share all proceeds generated from litigation relating to the Patent, including judgments and licenses or other arrangements entered into in settlement of any such litigation. Trebuchet is also entitled to recoup any litigation expenses specifically awarded to the Company in such actions.

Under the terms of the Agreement, and in consideration for Trebuchet’s funding agreement, the Company assigned and transferred a 49% interest of all of the Company’s right, title and interest in the Patent to Trebuchet which allows Trebuchet to have a separate and exclusive interest including a separate and distinct right to exploit the Patent. Pursuant to this transaction, the Company recognized a loss on the sale of patent assets for its assignment and transfer of 49% of its ownership rights in the patent, which had a net book value of approximately $1,670,000, for proceeds of $500,000. As a result, the Company recognized a loss on sale of patent assets of approximately $1,170,000. The Company considered this a triggering event and reviewed its remaining capitalized patent costs for impairment as of September 30, 2008. With the assistance of Trebuchet, the Company determined that the expected eventual outcome of the legal action and recoverability of proceeds or added economic value of the patent was still in excess of the current carrying amount.
 
9

 
5.     Revolving Notes
 
On January 4, 2008, the Company entered into a Credit Facility Agreement with Fagenson and Co., Inc., as agent, a related party to Robert B. Fagenson, the Chairman of the Company's Board of Directors. Under the Fagenson Credit Agreement, the Company can borrow up to a maximum of $3,000,000 from time to time up to and until January 4, 2010. The advances are generally limited to $400,000 unless otherwise mutually agreed upon by both parties per fiscal quarter, with the exception of $600,000 that can be advanced at any time for patent litigation related bills. Any amount borrowed by the Company pursuant to the Fagenson Credit Agreement will have an annual interest rate of 2% above LIBOR and will be secured by the Common Stock of Plastic Printing Professionals, Inc., (“P3”) the Company's wholly owned subsidiary. Interest is payable quarterly in arrears and the principal is payable in full at the end of the term under the Fagenson Credit Agreement. In addition, on January 4, 2008, the Company also entered into a Credit Facility Agreement with Patrick White, the Company's Chief Executive Officer and a member of the Board of Directors. Under the White Credit Agreement, the Company can borrow up to $600,000 from time to time up to and until January 4, 2010. Any amount borrowed by the Company pursuant to the White Credit Agreement will have an annual interest rate of 2% above LIBOR and will be secured by the accounts receivable of the Company, excluding the accounts receivable of P3. Interest is payable quarterly in arrears and the principal is payable in full at the end of the Term under the White Credit Agreement. Mr. White can accept common stock as repayment of the loan upon a default. Under the terms of the agreement the Company is required to comply with various covenants. During the year ended December 31, 2007, Patrick White advanced the Company $300,000 while the terms of the credit facility were being finalized. As of September 30, 2008, the Company was in technical default of both agreements due to a failure to pay interest when due. Both Fagenson and Co., Inc. and Patrick White have agreed to waive the defaults through January 1, 2010.
 
As of September 30, 2008, the Company had outstanding $450,000 under the White Credit Agreement, $1,408,000 under the Fagenson Credit Agreement. Interest expense amounted to $63,000 for the nine month period ending September 30, 2008 and is included in accrued expenses as of September 30, 2008.
 
On May 7, 2008 the Company entered into a $500,000 unsecured credit facility with Taiko III Corp to fund the Company’s ongoing patent infringement and related lawsuits against the European Central Bank. Interest shall accrue on the unpaid principal amount at a 6% annual rate. The outstanding principal amount may be prepaid by the Company, in whole but not in part and including the full interest through the maturity of the loan, at its option so long as the Company provides Taiko III with prior written notice of such prepayment. The term of the line of credit is 364 days. In addition, the loan can be repaid by the Company, at the discretion of Taiko III if the Company had defaulted under the credit facility, by using the Company’s common stock at a discount to the market value at the time of the repayment at 33% to market at the time of payment at no less than $2.00 per share and no more than $5.00 per share. On August 20, 2008, the Company entered into an agreement with Trebuchet Capital Partners, which, among other things, called for Trebuchet to pay the Company $500,000, which the Company used to pay in full the Company’s existing obligation owed to Taiko III Corp. See Note 4.
 
6.     Shareholders’ Equity
 
Stock Issued for Patent Defense Costs - On November 14, 2006, the Company entered into an stock payment agreement with McDermott Will & Emery LLP (“MWE”), its lead counsel on its European Central Bank (“ECB Litigation”) patent infringement and related cases. The agreement with MWE allows the Company to use its common stock to eliminate the Company’s cash requirements for MWE’s legal fees related to the ECB validity litigation, not to exceed $1.2 million in stock. During the nine months ended September 30, 2007, 60,866 restricted common shares were issued to MWE to pay for approximately $746,000 of legal fees incurred through September 30, 2007.

Stock Issued in Private Placement - On June 25, 2008 the Company entered into two Share Purchase Agreements pursuant to which the Company agreed to sell a total of 500,000 shares of the Company’s common stock for an aggregate purchase price of $2,000,000. Pursuant to the terms of the first Agreement, the Company sold 150,000 shares of Common Stock to the Purchaser for $600,000 payable on June 25, 2008. Pursuant to the terms of the second Agreement, the Company sold 350,000 shares of Common Stock for $1,400,000, with $100,000 payable on June 25, 2008 and the remaining $1,300,000 payable in six-month installments over a two-year period. Pursuant to the terms of the first Agreement, the Purchaser may not sell the 150,000 shares of Common Stock purchased thereunder earlier than June 25, 2009. Pursuant to the terms of the second Agreement, the Purchaser may not sell the 350,000 shares of Common Stock purchased thereunder until the earlier of (i) one year after the Purchase Price being paid in full to the Company, or (ii) the one-year anniversary of a Payment Failure Termination Event (as defined in the second Agreement). (See Note 10 -Commitments)

On January 22, 2007, the Company sold 6 units at a price of $50,000 per unit for gross proceeds of $300,000 consisting of 35,280 unregistered shares of the Company’s common stock and five-year warrants to purchase up to an aggregate of 17,640 shares of the Company’s common stock at an exercise price of $11.75 per share. The fair market value of these warrants was determined using the Black Scholes option pricing model at $107,000.

On August 20, 2008, the Company entered into an agreement with Trebuchet Capital Partners, LLC who agreed to pay substantially all of the litigation costs associated with pending validity proceedings initiated by the ECB in eight European countries relating to the Company’s European Patent 0 455 750B1 that the Company has claimed the ECB infringed in printing of the Euro currency. Trebuchet has also purchased 100,000 shares of the Company’s common stock, for an aggregate purchase price of $400,000, the proceeds of which were used by the Company to pay existing litigation cost.
 
10

 
Restricted Stock – As of September 30, 2008, there are 42,793 unvested restricted shares granted to employees and consultants that vest through June 2009. In addition, there are 195,000 restricted shares that will vest only upon the occurrence of certain events over the next 4 years, which include, among other things a change of control of the Company or other merger or acquisition of the Company, the achievement of certain financial goals, including among other things a successful result of the Company’s patent infringement lawsuit against the European Central Bank. These 195,000 shares, if vested, would result in the recording of stock based compensation expense of approximately $2,438,000, the grant date fair value, over the period beginning when any of the contingent vesting events is deemed to be probable over the expected requisite service period. As of September 30, 2008, vesting is not considered probable and no compensation expense has been recognized related to the performance grants. On May 10, 2008, the Company accelerated the vesting of 33,333 restricted shares and retired 250,000 of unvested restricted stock as the result of a separation agreement with the Company’s former President. The 33,333 shares of restricted stock, formerly set to vest pro-ratably through June 2009, were accelerated to vest pro-ratably on a monthly basis over a ten-month vesting period ending in March 2009. As a result of the acceleration of the 33,333 shares of restricted stock, the Company recognized approximately $194,000 of stock based compensation during the second quarter of 2008. (See Note 10 -Commitments)
 
Stock Options– During the nine months ended September 30, 2008, the Company issued options to purchase 37,000 of its common shares at an exercise price of $6.31 per share to non-employee directors pursuant to the 2004 Non-Employee Officer Director Stock Option Plan that vest at the end of one of year of service on the Company’s Board of Directors. The Company also issued options to purchase 50,000 of its common shares at an exercise price of $5.68 per share to employees pursuant to the 2004 Employee Stock Option Plan that will vest over three years. The aggregate fair value of these options amounted to approximately $220,000 determined by utilizing the Black Scholes option pricing model. The Company records stock-based payment expense related to these options based on the grant date fair value in accordance with FASB 123R.
 
Stock Warrants– During the nine months ended September 30, 2008, the Company received $100,000 in proceeds from the exercise of warrants to purchase 50,000 shares of our common stock. During the nine months ended September 30, 2007, the Company received approximately $55,000 in proceeds from the exercise of warrants to purchase 12,125 shares of our common stock. 

Stock-Based Compensation - Stock-based compensation includes expense charges for all stock-based awards to employees, directors and consultants. Such awards include option grants, warrant grants, and restricted stock awards. During the nine months ended September 30, 2008, the Company recognized approximately $1,536,000 ($971,000- 2007) in stock-based compensation. Approximately $194,000 of the expense was the result of the acceleration of vesting of restricted shares to the Company’s former President as the result of his separation from the Company in May 2008.

As of September 30, 2008, there was approximately $816,000 of total unrecognized compensation costs related to non-vested options and restricted stock granted under the Company’s stock option plans which the Company expects to vest over a period of not to exceed five years.

On August 13, 2008, the Company cancelled 330,500 employee stock options with exercise prices ranging from $6.24 to $12.50, and replaced the cancelled options with 330,500 employee stock options with an exercise price of $6.00. No other terms of the options were modified. On the date of grant, the fair market value of the Company’s Common Stock was $5.15. The repricing was treated as a modification under FAS123R, and resulted in an additional aggregate fair value expense determined using the Black- Scholes option pricing model of approximately $225,000, of which approximately $170,000 was expensed as of the grant date for fully vested options. The remaining fair value of the modified options will be expensed proratably during the expected vesting period of the options thru 2010.

7.   Other Income
 
On May 31, 2008, the Company was awarded a judgment of approximately $126,000 pursuant to a positive judgement for the Company in its counterclaim the matter “Frank LaLoggia v. Document Security Systems, Inc”, which the Company won in June 2006. The Company expects to collect the full amount of the judgment.
 
11

 
8.     Discontinued Operations

On September 25, 2007, the Company sold certain assets and the operations of its retail copying and quickprinting operations to an unrelated third party for $80,000 and the assumption of ongoing operating leases. The sale included fixed assets with a net book value of approximately $37,000. The Company recognized a gain on the sale of approximately $43,000. In accordance with SFAS 144, the disposal of assets constitutes a component of the entity and has been accounted for as discontinued operations. The operating results relating to these assets are segregated and reported as discontinued operations in the accompanying 2007 consolidated statement of operations. The results of operations directly attributed to the division’s operations that have been reclassified from continuing operations are as follows:

     
 Three Months Ended
 
 Nine Months Ended
 
   
 September 30, 2007
 
 September 30, 2007
 
             
Revenues
 
$
72,791
   
292,282
 
Cost of sales
   
48,720
   
150,525
 
Operating expenses
   
67,878
   
200,990
 
Income from discontinued operations
 
$
(43,807
)
 
(59,233
)
 
9.     Earnings Per Share

Basic earnings per share is computed by dividing net income by the weighted-average number of common shares outstanding for the period. Diluted earnings per share is computed by including the number of additional shares that would have been outstanding if dilutive potential shares had been issued. In periods of losses, diluted loss per share is computed on the same basis as basic loss per share as the inclusion of any other potential shares outstanding would be anti-dilutive.  If the Company had generated earnings during the nine month period ended September 30, 2008, 426,980 (767,887- 2007) common equivalent shares would have been added to the weighted average shares outstanding to compute the diluted weighted average shares outstanding.

10.     Commitments and Contingencies
 
Legal Matters
 
On August 1, 2005, the Company commenced a suit against the European Central Bank (“ECB”) alleging patent infringement by the ECB and claimed unspecified damages. The suit was brought in European Court of First Instance in Luxembourg. The Company alleged that all Euro banknotes in circulation infringe the Company European Patent 0 455 750B1 (the “Patent”), which covers a method of incorporating an anti-counterfeiting feature into banknotes or similar security documents to protect against forgeries by digital scanning and copying devices. The Court of First Instance ruled on September 5, 2007 that it does not have jurisdiction to rule on the patent infringement claim, and also ruled that the Company will be required to pay attorneys and court fees of the ECB. The ECB formally requested the Company to pay attorneys and court fees in the amount of Euro 93,752 ($144,000), which, unless the amount is agreed will be subject to an assessment procedure that will not likely be concluded until approximately the end of 2008, which the Company will accrue as soon as the assessed amount, if any, is estimatable.

On March 24, 2006, the Company received notice that the ECB has filed a separate claim in the United Kingdom and Luxembourg courts seeking the invalidation of the Patent. Proceedings were commenced before the national courts seeking revocation and declarations of invalidity of the Patent in each of the Netherlands, Belgium, Italy, France, Spain, Germany and Austria. On March 26, 2007, the High Court of Justice, Chancery Division, Patents Court in London, England (the “English Court”) ruled that the Patent was deemed invalid in the United Kingdom, and on March 19, 2008 this decision was upheld on appeal. The English Court rejected the ECB’s allegations of invalidity based on lack of novelty, lack of inventive step and insufficiency, but held that the patent was invalid for added subject matter. The English Court’s decision does not affect the validity of the Patent in other European countries. On March 30, 2007, the English Court awarded the ECB 30% of their costs (including legal fees) of the initial trial, of which the Company paid 90,000 British pounds ($182,000) on April 19, 2007. We expect that an additional 90,000 pounds ($162,000 at September 30, 2008) will become payable by the Company for the costs of the initial trial, which is included in accrued expenses as of September 30, 2008. In July 2007, the Company posted a bond of 87,500 British pounds ($157,500 at September 30, 2008), as collateral for the appeal costs which is recorded as restricted cash at September 30, 2008. On June 19, 2008, the Company paid 87,500 British pounds ($177,000 based on the applicable exchange rate on that date) towards the ECB’s costs of the English appeal. The Company may also owe additional legal fees associated with the Court of Appeal decisions, which, unless otherwise agreed by the parties, will be subject to an assessment procedure that will not likely be concluded earlier than the first quarter of 2009. The Company will record the assessed amount, if any, as soon as it is estimatable.
 
12

 
On March 27, 2007 the Bundespatentgericht of the Federal Republic of Germany ruled that the German part of the Patent was valid, having considered the English Court’s decision. As a result of this ruling, the Company expects to be awarded reimbursements for its costs associated with the German validity case, which is Euro 44,692 ($64,000 at September 30, 2008), which the Company will record when the amount, if any, is received. The ECB has filed an appeal against that decision, which is not expected to be decided before 2010. On January 9, 2008 the French Court held that the Patent was invalid in France for the same reasons given by the English Court. The Company is required to pay de minimus attorneys’ fees of the ECB as a result of the French decision. The Company filed an appeal against the French decision on May 7, 2008. On March 12, 2008 the Dutch Court, having considered the English, German and French decisions, ruled that the Patent is valid in the Netherlands. The ECB filed an appeal against the Dutch decision on March 27, 2008. A trial was also held in Madrid, Spain on June 3 and 5, 2008 and oral and written closing submissions were made on July 19, 2008. A judgment is expected in the fourth quarter of 2008.
 
The Patent has thus been confirmed to be valid and enforceable in two jurisdictions (Germany and the Netherlands) that use the Euro as its national currency. Additional trials on the validity of the Patent are expected in other European jurisdictions in 2008 and 2009.

On August 20, 2008, the Company entered into an agreement with Trebuchet Capital Partners, LLC (“Trebuchet”) under which Trebuchet has agreed to pay substantially all of the litigation costs associated with pending validity proceedings initiated by the European Central Bank (“ECB”) in eight European countries relating to the Company’s European Patent 0 455 750B1 that the Company has claimed the ECB infringed in printing of the Euro currency (the “Patent”). Trebuchet also agreed to pay substantially all of the litigation costs associated with future validity challenges filed by the ECB or other parties, provided that Trebuchet elects to assume the defense of any such challenges, in its sole discretion, and patent infringement suits filed against the ECB and certain other alleged infringers of the Patent, all of which suits may be brought at the sole discretion of Trebuchet and may be in the name of the Company, Trebuchet or both. The Company provided Trebuchet with the sole and exclusive right to manage infringement litigation relating to the Patent in Europe, including the right to initiate litigation in the name of the Company, Trebuchet or both and to choose whom and where to sue, subject to certain limitations set forth in the agreement. Under the terms of the Agreement, the Company and Trebuchet have agreed to equally share all proceeds generated from litigation relating to the Patent, including judgments and licenses or other arrangements entered into in settlement of any such litigation. Trebuchet is also entitled to recoup any litigation expenses specifically awarded to the Company in such actions.
 
On January 31, 2003, the Company commenced an action, unrelated to the above ECB litigation, entitled New Sky Communications, Inc., As Successor-In-Interest To Thomas M. Wicker, Thomas M.Wicker Enterprises, Inc. and Document Security Consultants V. Adler Technologies, Inc. N/K/A Adlertech International, Inc. and Andrew McTaggert (United States District Court, Western District Of New York Case No.03-Cv-6044t(F)) regarding certain intellectual property in which the Company has an interest. The Company commenced this action alleging various causes of action against Adler Technologies, Inc. and Andrew McTaggert for breach of contract, breach of the duty of good faith and fair dealing, various business torts, including unfair competition and declaratory relief. Adler distributes and supplies anti-counterfeit document products and Mr. McTaggert is a principal of Adler. Adler had entered into several purported agreements with Thomas M. Wicker Enterprises and Document Security Consultants, both of which the Company acquired in 2002. These alleged agreements, generally, would have authorized Adler to manufacture in Canada the Company’s “Checkmate®” patented system for verifying the authenticity of currency and documents. Other purported agreements were signed between these parties and Thomas Wicker regarding other technology claimed to have been owned by Wicker and assigned to the Company. Among other things, the Company contends that certain of the purported agreements are not binding and/or enforceable. To the extent any of them are binding and enforceable, the Company claims that Adler has breached these purported agreements, failed to make an appropriate accounting and payments under them, and may have exceeded the scope of its license. Adler has denied the material allegations of the complaint and has counterclaimed against the Company, claiming Adler owns or co-owns or has a license to use certain of the Company’s technologies. In May 2005, the Company filed a first amended and supplemental complaint adding Blanks/USA and Raymond Maxon as additional defendants. In February 2007, the Company filed a second amended and supplemental complaint adding Judith Wu (McTaggert’s wife) and Arcis Digital Security, Inc. (a company in which Ms. Wu is involved) as additional defendants. Maxon has asserted a counterclaim against the Company contending that the Company’s purported acquisition of a certain patent from Thomas Wicker in 2002 gave rise to an alleged right on the part of Maxon to receive a portion of Thomas Wicker’s proceeds from such acquisition. The Company has denied the material allegations of all of the counterclaims. If Adler or Maxon is successful, it may materially affect the Company, the Company’s financial condition, and the Company’s ability to market and sell certain of the Company technology and related products. This case is in discovery phase, and it is too soon to determine how the various issues raised by the lawsuit will be determined.
 
13

 
In addition to the foregoing, the Company is subject to other legal proceedings that have arisen in the ordinary course of business and have not been finally adjudicated. Although there can be no assurance in this regard, in the opinion of management, none of these legal proceedings to which the Company is a party to will have a material adverse effect on the Company results of operations, cash flows or the Company’s financial condition.
 
Commitments
 
In May 2008, the Company entered into a Separation Agreement with its former President that, among other things, accelerated the vesting of 33,333 shares of restricted common stock of the Company that were previously awarded to the former President pursuant to the Company’s 2004 Employee Stock Option Plan so that such shares vested in equal monthly installments during the immediately following ten months. The Separation Agreement further provided that if the former President did not realize at least $212,000 in gross proceeds from the sale of such 33,333 shares of restricted stock upon their vesting, then the Company would pay the former President the amount that such proceeds is less than $212,000 in cash or additional shares of common stock of the Company. As of September 30, 2008, 13,333 of such 33,333 shares had vested generating gross proceeds of approximately $48,000.
 
In June 2008, the Company entered into two Stock Purchase Agreements in which it sold 500,000 shares of its common stock to Walton Invesco Inc. for an aggregate purchase price of $2.0 million. Pursuant to the terms of such Stock Purchase Agreements, Walton Invesco Inc. may demand registration of such 500,000 shares with the Securities and Exchange Commission on Form S-3 with such registration statement to take effect no later than (i) 120 days after payment in full for such shares under the applicable agreement or, (ii) with respect to 350,000 shares, 270 days after a Payment Failure Termination Event (as defined in the applicable Stock Purchase Agreement).
 
Pursuant to an agreement made in December 2004, the Company is required to share the economic benefit derived from settlements, licenses or subsequent business arrangements that the Company obtains from any infringer of patents formerly owned by the Wicker Family. For infringement matters involving certain U.S. patents, the Company will be required to disburse 30% of the settlement proceeds. For infringement matters involving certain foreign patents, including the lawsuit against the European Central Bank described in Part II Item 1 – Legal Proceedings, the Company will be required to disburse 14% of the settlement proceeds. These payments do not apply to licenses or royalties to patents that the Company has developed or obtained from persons other than the Wicker Family. As of September 30, 2008, there have been no settlement amounts related to these agreements.
 
In May 2005, the Company made an agreement with its legal counsel in charge of the Company’s patent infringement litigation in the Court of First Instance with the European Central Bank which capped its fees for all matters associated with that infringement litigation at $500,000 plus expenses, and a $150,000 contingent payment upon a successful ruling or settlement on the Company’s behalf in that litigation. The Company will record the $150,000 in the period in which the Company has determined that a successful ruling or settlement is probable.
 
11   Supplemental Cash Flow Information
 
During the nine months ended September 30, 2008, the Company issued 19,260 shares for the payment of approximately $94,000 of marketing expenses. During the nine months ended September 30, 2007, the Company issued 60,866 shares of Common Stock valued at approximately $746,000 in conjunction with the payment of legal expenses which were capitalized as other intangible assets. In addition, the Company extended the term of previously issued warrants to a warrant holder in exchange for a license valued at approximately $521,000. In addition, during 2007, the Company issued fully vested, nonforfeitable warrants to consultants of approximately $525,000 that were recorded as a prepaid expense that was recognized as stock based compensation. As of September 30, 2008, all of this amount had been recognized as expense.
 
14

 
12.     Segment Information
 
The Company's businesses are organized, managed and internally reported as three operating segments. Two of these operating segments, Document Security Systems and Plastic Printing Professionals, are engaged in various aspects of developing and applying printing technologies and procedures to produce, or allow others to produce, documents with a wide range of features, including the Company’s patented technologies and trade secrets. For the purposes of providing segment information, these two operating segments have been aggregated into one reportable segment in accordance with Financial Accounting Standards Board (“FASB”) Statement No. 131- “Disclosures about Segments of an Enterprise and Related Information”. A summary of the Company’s two segments is as follows:
 
Document Security and Production
 
License, manufacture and sale of document security technologies, including digital security print solutions and secure printed products at Document Security Systems and Plastic Printing Professionals divisions. In September 2007, the Company sold substantially all of the assets of its retail printing and copying division, a former component of the Document Security and Production segment, to an unrelated third party as this operation was not critical to the Company’s core operations. The results of the retail and copying division are reported as discontinued operations and are not a component of these segment results (See Note 8).
     
Legal Supplies
 
Sale of specialty legal supplies, primarily to lawyers and law firms located throughout the United States via the website Legalstore.com.

            Approximate information concerning the operations by reportable segment for the three and nine months ended September 30, 2008 and 2007 is as follows. The Company relies on intersegment cooperation and management does not represent that these segments, if operated independently, would report the results contained herein:
 
 
 
  
 
 Document 
 
  
      
        
 Security &
           
   
 Legal Supplies
 
 Production
 
 Corporate 
 
 Total
 
3 months ended September 30, 2008:                  
Revenues from external customers
 
$
151,000
 
$
1,523,000
 
$
-
 
$
1,674,000
 
Depreciation and amortization
   
4,000
   
615,000
   
1,000
   
620,000
 
Segment profit (loss) from continuing operations
   
(6,000
)
 
(2,046,000
)
 
(611,000
)
 
(2,663,000
)
Identifiable assets
   
328,000
   
7,479,000
   
548,000
   
8,355,000
 
                           
3 months ended September 30, 2007:                          
Revenues from external customers
 
$
176,000
 
$
1,233,000
 
$
-
 
$
1,409,000
 
Depreciation and amortization
   
4,000
   
521,000
   
1,000
   
526,000
 
Segment profit (loss) from continuing operations
   
(13,000
)
 
(799,000
)
 
(1,069,000
)
 
(1,881,000
)
Identifiable assets
   
255,000
   
10,564,000
   
1,562,000
   
12,381,000
 
 
 
 
  
 
 Document 
 
  
      
        
 Security &
           
 
 
 Legal Supplies
 
 Production
 
 Corporate
 
 Total
 
9 months ended September 30, 2008:                       
Revenues from external customers
 
$
483,000
 
$
4,847,000
 
$
-
 
$
5,330,000
 
Depreciation and amortization
   
12,000
   
1,827,000
   
3,000
   
1,842,000
 
Segment profit (loss) from continuing operations
   
29,000
   
(4,293,000
)
 
(1,918,000
)
 
(6,182,000
)
Identifiable assets
   
328,000
   
7,479,000
   
548,000
   
8,355,000
 
                           
9 months ended September 30, 2007:                          
Revenues from external customers
 
$
513,000
 
$
3,820,000
 
$
-
 
$
4,333,000
 
Depreciation and amortization
   
10,000
   
1,356,000
   
30,000
   
1,396,000
 
Segment profit (loss) from continuing operations
   
(11,000
)
 
(2,217,000
)
 
(2,547,000
)
 
(4,775,000
)
Identifiable assets
   
255,000
   
10,564,000
   
1,562,000
   
12,381,000
 
 
13.     Subsequent Events
 
On November 6, 2008 the Company entered into an asset purchase agreement to acquire the assets of DPI of Rochester, LLC (“DPI”), which agreement is subject to court approval in DPI’s pending Chapter 11 bankruptcy case. DPI is a full service digital and commercial offset printer located in Rochester, NY with approximately $7.6 Million in annual sales in 2007. The estimated purchase price is $1,000,000 plus the assumption of certain equipment leases, and the Company may provide debtor-in-possession financing, subject to United States Bankruptcy Court approval, to DPI during its Chapter 11 reorganization process to prevent any disruption of service to DPI’s customers. The purchase of assets is expected to be completed in the quarter ended December 31, 2008 and is subject to the United States Bankruptcy Court approval and an opportunity for other parties to overbid for DPI’s assets. The obligations under the agreement are conditioned upon the negotiation of real and personal property leases, the approval of the bankruptcy court and other matters. There can be no assurance that the transaction contemplated by the purchase agreement will be approved by the bankruptcy court or that the conditions to closing will be met. Upon court approval of the transaction, the purchase price, once known, will be allocated to the assets acquired based on their respective fair values.
 
15

ITEM 2 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
 
FORWARD-LOOKING STATEMENTS
 
Certain statements contained herein constitute “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995 (the “1995 Reform Act”). Document Security Systems, Inc. desires to avail itself of certain “safe harbor” provisions of the 1995 Reform Act and is therefore including this special note to enable us to do so. Except for the historical information contained herein, this report contains forward-looking statements (identified by the words "estimate," "project," "anticipate," "plan," "expect," "intend," "believe," "hope," "strategy" and similar expressions), which are based on our current expectations and speak only as of the date made. These forward-looking statements are subject to various risks, uncertainties and factors, including, without limitation, those contained in our Form 10-K for the year ended December 31, 2007 and those described herein that could cause actual results to differ materially from the results anticipated in the forward-looking statements.
 
Overview
 
Document Security Systems, Inc. (referred to in this report as “Document Security,” “we,” “us,” “our” or “Company”) markets and sells products designed to protect valuable information from unauthorized scanning, copying, and digital imaging. We develop sophisticated security technologies that are applied during the normal printing process and by virtually all printing methods including traditional offset, gravure, flexo, digital or via the Internet on paper, plastic, or packaging. We believe we are a leader of customized document protection solutions for companies and governments worldwide. We hold eight patents that protect our technology and have over a dozen patents in process or pending. Our technologies and products are used by federal, state and local governments, law enforcement agencies and are also applied by a broad variety of industries,, including financial institutions, high technology and consumer goods, entertainment and gaming, healthcare/pharmaceutical, defense and genuine parts industries. Our customers use our technologies where there is a need for enhanced security for protecting and verification of critical financial instruments and vital records, or where there are concerns of counterfeiting, fraud, identity theft, brand protection and liability.

Our core business is counterfeit prevention, brand protection and validation of authentic print media, including government-issued documents, currency, private corporate record and, securities. We believe we are a world leader in the research and development of optical deterrent technologies and have commercialized these technologies with a broad suite of products that offer our customers a wide array of document security solutions to satisfy their specific anti-counterfeiting requirements. Our technology can be used in securing sensitive and critical documents such as currency, automobile titles, spare parts forms for the aerospace industry, gift certificates, permits, checks, licenses, receipts, prescription and medical forms, engineering schematics, ID cards, labels, original music, coupons, homeland security manuals, consumer product and pharmaceutical packaging, tickets, and school transcripts. In addition, we have developed a digital product to implement our technologies in Internet-based environments utilizing standard desktop printers. We believe that our digital technology greatly expands the reach and potential market for our technologies and solutions.

Technologies

We have developed or acquired over 30 technologies that provide to our customers a wide spectrum of solutions. Our primary anti-counterfeiting products and technologies are marketed under the AuthentiGuard trade names.

Products and Services

Document Security Solutions and Production: Our technology portfolio allows us to create unique custom secure paper, plastic, packaging and Internet-based solutions. We market to end-users that require anti-counterfeiting and authentication features in a wide range of printed materials like documents, vital records, driver’s licenses, birth certificates, receipts, manuals, identification materials, entertainment tickets, coupons, parts tracking forms, as well as product packaging including pharmaceutical and a wide range of consumer goods. We manufacture plastic ID cards at our wholly owned subsidiary called Plastic Printing Professionals, in San Francisco, CA, and we produce our custom security paper products either internally at our small printing facility in Rochester, NY, or outsourced at our various licensees. Through our strategic licensee program, we can offer our customers a wide range of production capabilities to meet the customized requirements.

16


Security Paper: Our primary product for the retail end-user market is AuthentiGuard Security Paper. AuthentiGuard Security Paper uses our Pantograph 4000 technology, and is a paper that reveals hidden warning words, logos or images using The Authenticator - our proprietary viewing lens – or when the paper is faxed, copied, scanned or re-imaged. The hidden warning words appear on the duplicate or the computer digital file and essentially prevents important documents from being counterfeited. We market and sell our Security Paper primarily through two major paper distributors: Boise Cascade and PaperlinX Limited.

Technology Licensing: We license our anti-counterfeiting technology and trade secrets through licensing arrangements with security printers. We seek licensees that have a broad customer base that can benefit from our technologies or have unique and strategic capabilities that expand the capabilities that we can offer our potential customers. Revenue from licensing can take several forms. Licenses can be for a single technology or for a package of technologies.  

Digital Solutions: We also offer our technologies in digital forms that are deliverable via internet and intranet environments. In October 2008, we launched our first branded digital solution called AuthentiGuard® DX. AuthentiGuard® DX is a networked appliance that allows the author of any Microsoft Office document (Outlook, Word, Excel, or PowerPoint) to secure nearly any of its alphanumeric content when it is printed or digitally stored. AuthentiGuard® DX prints selected content using our patented technology so that it cannot be read by the naked eye. Reading the hidden content or authenticating the document is performed with a proprietary viewing device or software.

Additionally, we sell custom hosted or server-based digital solutions for our customers. Depending on our customer’s specific requirements, we host a secure server that accepts user inputs and delivers custom, variable secure documents for output at the user location, or offer a bundled server solution that allows for the production of custom, variable secure documents within the user’s network environment.

Legal Products: We also own and operate Legalstore.com, an Internet company which sells legal supplies and documents, including security paper and products for the users of legal documents and supplies in the legal, medical and educational fields. While not a component of our core business strategy, we continuously seek to maximize the revenue and profitability of this operation.
 
Results of Operations for the Three and Nine Months Ended September 30, 2008
 
The following discussion and analysis provides information that our management believes is relevant to an assessment and understanding of our results of operations and financial condition. The discussion should be read in conjunction with the financial statements and footnotes in this quarterly report and in our annual report on Form 10-K for the year ended December 31, 2007. On September 25, 2007, the Company sold its copying and quick-printing business to an unrelated third party. In accordance with FASB 144, the Company accounts for the revenue and expenses of this operation, which was a component of its security printing segment, as a discontinued operation. All amounts have been adjusted to reflect the Company’s results after the effect of discontinued operations.
 
Revenue
 
   
Three Months 
Ended September
30, 2008
 
Three Months 
Ended September
30, 2007
 
% change vs.
2007
 
Nine Months 
Ended September
30, 2008
 
Nine Months 
Ended September
30, 2007
 
% change vs.
2007
 
Revenue
                                     
Security printing & products
 
$
1,334,000
 
$
946,000
   
41
%
$
3,421,000
 
$
2,765,000
   
24
%
Royalties
   
181,000
   
278,000
   
-35
%
 
1,402,000
   
871,000
   
61
%
Digital solutions
   
8,000
   
9,000
   
-11
%
 
25,000
   
184,000
   
-86
%
Legal products
   
150,000
   
176,000
   
-15
%
 
483,000
   
513,000
   
-6
%
Total Revenue
   
1,673,000
   
1,409,000
   
19
%
 
5,331,000
   
4,333,000
   
23
%
 
For the three months ended September 30, 2008, revenue increased 19% from the same period in 2007. The increase in revenue was primarily the result of strong growth in sales of our security products. The Company has sought to become a full-service provider of printing and production for its customers. During the quarter, the Company saw 20% sales growth at its Plastic Printing division as that division began to see the benefit of recent capital investments that increased its production capacity and expanded its production capabilities. Sales for paper based security products grew 30% from the same quarter of 2007, as the Company benefited from increased sales of its safety paper for prescriptions, and custom projects, including voter registration paper used for a foreign election, and coupons for a Fortune 500 customer.

17

 
Royalty revenue decreased primarily due to the absence of royalty revenue as a result of the new agreement with the Ergonomics Group in the second quarter of 2008, as described below, which previously had contributed approximately $60,000 per quarter of royalty revenue. Otherwise, royalty revenue reflected reductions in technology usage reported by its remaining licensing customers.
 
Legalstore.com saw an approximately 15% decline in orders from the 2007 quarter, which we believe was due to slowing conditions in the general economy along with the effects of an issue with its adword placements on one of the major search engine sites. The Company addressed its adword issue at the end of the quarter, and expects legal products to return to historical levels in the fourth quarter of 2008.
 
For the first nine months of 2008, revenue increased 23% compared to the first nine months of 2007 primarily as a the result of the significant impact of royalty revenue recognized in the second quarter of 2008 along with a 24% growth in the company’s sales of its security printing and products. During the second quarter of 2008, the Company recognized approximately $542,000 of previously deferred royalty revenue as the result of a new agreement with the Ergonomic Group in April 2008. Under a previous agreement with the Ergonomic Group, the Company received $1,000,000 in non-refundable license and royalty fees, of which $500,000 was recognized as royalty revenue pro-ratably over a two year license period and the remaining $500,000 was considered a prepaid royalty, to be recognized as revenue when sales of products using the licensed technology were made. This agreement was cancelled and a new agreement with the Ergonomic Group that covers the Company’s newest digital technologies was established. As a result, the non refundable license and royalty payment no longer met the criteria for deferral and was recognized in the second quarter of 2008.
 
These growth areas were partially offset by a significant decline in digital solutions sales during the first nine months of 2008 as compared to the first nine months of 2007 due to the absence of any digital solutions implementations during 2008.
 
Cost of Sales and Gross Profit
 
   
Three Months 
Ended September
30, 2008
 
Three Months 
Ended September
30, 2007
 
% change vs.
2007
 
Nine Months 
Ended September
30, 2008
 
Nine Months 
Ended September
30, 2007
 
% change vs.
2007
 
                           
Costs of revenue
                                     
Security printing & products
 
$
636,000
 
$
636,000
   
0
%
$
2,028,000
 
$
1,691,000
   
20
%
Digital solutions
   
4,000
   
3,000
   
33
%
 
11,000
   
41,000
   
-73
%
Legal products
   
86,000
   
83,000
   
4
%
 
258,000
   
276,000
   
-7
%
Total cost of revenue
   
726,000
   
722,000
   
1
%
 
2,297,000
   
2,008,000
   
14
%
                                       
Gross profit
                                     
Security printing & products
   
698,000
   
310,000
   
125
%
 
1,393,000
   
1,074,000
   
30
%
Royalties
   
181,000
   
278,000
   
-35
%
 
1,402,000
   
871,000
   
61
%
Digital solutions
   
4,000
   
6,000
   
-33
%
 
14,000
   
143,000
   
-90
%
Legal products
   
64,000
   
93,000
   
-31
%
 
225,000
   
237,000
   
-5
%
Total gross profit
   
947,000
   
687,000
   
38
%
 
3,034,000
   
2,325,000
   
30
%
 
    
Three Months 
Ended September
30, 2008
 
Three Months 
Ended September
30, 2007
 
% change vs.
2007
 
Nine Months 
Ended September
30, 2008
 
Nine Months 
Ended September
30, 2007
 
% change vs.
2007
 
Gross profit percentage:
                                     
Gross profit percentage:
   
57
%
 
49
%
 
16
%
 
57
%
 
54
%
 
6
%
 
Gross profit increased 38% to $947,000 in the thrid quarter of 2008 as compared to the $687,000 of gross profit realized in the third quarter of 2007, primarily the result of stong sales of the company’s security printing and products and the ability of the Company to increase its margins through operating efficiencies and material cost savings that the Company was able to generate at its plastics division’s new facility. The increase in gross profits of this group was partially offset by decreases in royalty, digital solution and legal products profits, respectively, for reasons discussed above. For the nine months ended September 30, 2008, the Company’s gross profit increased at a slightly higher rate as the Company’s gross profit percentage increased 6 percentage points as compared to the 2007 period.
 
18

 
Operating Expenses 
 
   
Three Months 
Ended September
30, 2008
 
Three Months 
Ended September
30, 2007
 
% change vs.
2007
 
Nine Months 
Ended September
30, 2008
 
Nine Months 
Ended September
30, 2007
 
% change vs.
2007
 
                           
Selling, general and administrative
                                     
General and administrative compensation
 
$
539,000
 
$
514,000
   
5
%
$
1,622,000
 
$
1,310,000
   
24
%
Professional Fees
   
206,000
   
352,000
   
-41
%
 
780,000
   
1,036,000
   
-25
%
Sales and marketing
   
204,000
   
466,000
   
-56
%
 
892,000
   
1,525,000
   
-42
%
Depreciation and amortization
   
42,000
   
20,000
   
110
%
 
126,000
   
61,000
   
107
%
Other
   
319,000
   
289,000
   
10
%
 
902,000
   
685,000
   
32
%
Research and development
   
73,000
   
111,000
   
-34
%
 
322,000
   
314,000
   
3
%
Stock based payments
   
480,000
   
338,000
   
42
%
 
1,506,000
   
971,000
   
55
%
Impairment of patent defense costs
   
-
   
-
         
292,000
   
-
       
Amortization of intangibles
   
541,000
   
480,000
   
13
%
 
1,605,000
   
1,259,000
   
27
%
                                       
Total Operating Expenses
   
2,404,000
   
2,570,000
   
-6
%
 
8,047,000
   
7,161,000
   
12
%
 
Selling, General and Administrative  
 
General and administrative compensation costs were 5% higher in the third quarter of 2008 as compared to the third quarter of 2007 which was primarily due to the impact of a bonus reversal of approximately $41,000 in the 2007 period, which offset the impact of salary reductions made by the Company during 2008. In addition, the 2008 amount reflects an increase in the cash compensation of the non-employee members of the Company’s board of directors.
 
Professional fees - The decrease in professional fees during the third quarter and first nine months of 2008 reflect significant decreases in non-patent related legal fees, accounting fees, and stock transfer and investor relations fees. These costs savings reflect reduced SEC compliance costs and decreased legal activity, along with the impact of the Company’s cost-cutting program it initiated in March 2008. For the nine months ended September 30, 2008, these cost savings were partially offset by increases in the use of consultants for sales and business development efforts during the first three months of 2008.
 
   
Three Months 
Ended September
30, 2008
 
Three Months 
Ended September
30, 2007
 
% change vs.
2007
 
Nine Months 
Ended September
30, 2008
 
Nine Months 
Ended September
30, 2007
 
% change vs.
2007
 
                           
Professional Fees Detail
                                     
Accounting and auditing
 
$
40,000
 
$
71,000
   
-44
%
$
213,000
 
$
236,000
   
-10
%
Consulting
   
79,000
   
95,000
   
-17
%
$
341,000
   
292,000
   
17
%
Legal Fees
   
43,000
   
120,000
   
-64
%
$
94,000
   
255,000
   
-63
%
Stock Transfer, SEC and Investor Relations
   
44,000
   
66,000
   
-33
%
$
132,000
   
253,000
   
-48
%
                                       
   
$
206,000
 
$
352,000
   
-41
%
$
780,000
 
$
1,036,000
   
-25
%
 
Sales and marketing expenses, including sales and marketing personnel costs, decreased in the third quarter and the first nine months of 2008 as the Company reduced sales and marketing headcount by four, reduced public relations and marketing costs and significantly reduced the amount spent on travel and entertainment. The Company reduced these costs as it realigned its sales process in order to maximize the results of its sales and marketing efforts with the goal of focusing of near term revenue opportunities.
 
Other operating expenses are primarily rent and utilities, office supplies, IT support, bad debt expense and insurance costs. Increases in the third quarter an first nine months of 2008 reflect costs increases associated with an increase in rent costs and one time costs associated with the move of the Company’s plastic printing division to a larger facility, higher utility costs, and an increase in insurance costs.

19

 
Stock-Based Compensation. Stock-based compensation includes expense charges for all stock-based awards to employees, directors and consultants. Such awards include option grants, warrant grants, and restricted stock awards. Stock-based compensation increases in the three and nine month periods ended September 30, 2008 reflect equity-based payments made to employees, directors, and third-party consultants, including approximately $194,000 of expense as the result of the acceleration of vesting of restricted shares and $18,000 due to the modification of options to the Company’s former President as the result of his separation from the Company in May 2008. In addition, on August 13, 2008, the Company cancelled 330,500 employee stock options with exercise prices ranging from $6.24 to $12.50, and replaced the cancelled options with 330,500 employee stock options with an exercise price of $6.00. No other terms of the options were modified. On the date of grant, the fair market value of the Company’s Common Stock was $5.15. The repricing was treated as a modification under FAS123R, and resulted additional aggregate fair value expense determined using the Black- Scholes option pricing model of approximately $225,000, of which approximately $170,000 was expensed as of the grant date for fully vested options. The remaining fair value of the modified options will be expense proratably during the expected vesting period of the options thru 2010.
 
Research and Development
 
We invest in research and development to improve our existing technologies and develop new technologies that will enhance our position in the document security market. Research and development costs consist primarily of compensation costs, and costs for the use of third-party printers’ facilities to test our technologies on equipment that we do not have access to internally. During the third quarter of 2008, the Company reduced its research and development by one person who was replaced on October 1, 2008.
 
Impairment of Patent Defense Costs
 
On March 19, 2008, the Company received notification that its appeal of the invalidation of its European Patent 455750B1 in the UK was not successful. As result of the adverse court decision, the Company recognized an impairment loss of $292,000 associated with the U.K appeal as of March 31, 2008. The impairment loss includes a judgment for reimbursement of estimated counterpart legal fees. The Company may be obligated to pay additional counter party legal fees associated with the decision, which the Company will expense as soon as the amount, if any, is estimatable.
 
Amortization of Intangibles
 
Amortization of intangibles expense increased 13% in the third quarter of 2008 as compared to the third quarter of 2007 which was primarily the result of an increase of $1.1 million in the Company’s capitalized patent defense costs from December 2007 to September 2008. We amortize the costs associated with patent rights that we acquired in 2005 and legal costs associated with the registration and defense of our patents, including the costs associated with our lawsuit against the ECB for patent infringement and the related ECB countersuits for patent validity. A significant portion of these assets were acquired by the issuance of equity-based instruments. On August 20, 2008, the Company entered into an agreement with Trebuchet Capital Partners which agreed to pay substantially all of the litigation costs associated with its ECB litigation. Under the terms of the agreement the Company transferred and assigned a 49% interest of all of the Company’s rights, title and interest in its European Patent 0455750B1 and the two parties agreed to equally share all proceeds generated from litigation relating to the Patent, including judgments and licenses or other arrangements entered into in settlement of any such litigation. The Company considered this a triggering event and reviewed its remaining capitalized patent costs related to the Patent for impairment as of September 30, 2008. With the assistance of Trebuchet, the Company determined that the expected eventual outcome of the legal action and recoverability of proceeds or added economic value of the patent was still in excess of the current carrying amount.
 
As a result of the Trebuchet agreement, and the transfer and assignment of our 49% interest in the patent, or $1,670,000, our net amortizable patent asset base at September 30, 2008 was approximately $2.9 million and will generate approximately $1.0 million in annual amortization expense during the next 3 years, as compared to approximately $2.0 million in annual amortization expense the Company was recognizing prior to the Trebuchet transaction.
 
In addition, the Company has approximately $683,000 of net other intangible assets as of September 30, 2008 that consist of a royalty right, a non-exclusive marketing right, as well as acquired intangibles including customer lists and a trade name. These assets will generate approximately $250,000 of annual amortization expense during the next 2.5 years. In addition, the Company has approximately $1,397,000 in goodwill derived from acquisitions. Goodwill is not amortized, but could become a component of expense if an impairment is determined. The Company reviews these assets for impairment annually or if a triggering event occurs. If an impairment, such as unfavorable ruling in the Company’s patent validity or infringement lawsuits or an assessment of non-commerciability of certain of its patents, then the Company would write-off a portion of these assets, which could be a significant expense in the period incurred.

20


Other Income and Expense
 
On May 31, 2008, the Company was awarded a judgment of approximately $126,000 pursuant to a counterclaim by the Company in the matter “Frank LaLoggia v. Document Security Systems, Inc”, which the Company won in June 2006. The Company expects to collect the full amount of the judgment.
 
On August 20, 2008, the Company entered into an agreement with Trebuchet Capital Partners, LLC. Pursuant to the Agreement, Trebuchet has agreed to pay substantially all of the litigation costs associated with pending validity proceedings initiated by the European Central Bank in eight European countries relating to the Company’s European Patent 0 455 750B1 that the Company has claimed the European Central Bank ("ECB") infringed in printing of the Euros currency. Under the terms of the Agreement, and in consideration for Trebuchet’s funding obligations, the Company assigned and transferred a 49% interest of the Company’s rights, title and interest in the Patent to Trebuchet which allows Trebuchet to have as a separate and exclusive interest including a separate and distinct right to exploit the Patent. Pursuant to this transaction, the Company recognized a loss on the sale of patent assets for its assignment and transfer of 49% of its ownership rights in the patent, which had a net book value of approximately $1,670,000, for proceeds of $500,000, As a result, the Company recognized a loss on sale of patent assets of approximately $1,170,000.
 
Net Loss and Loss Per Share
 
    
Three Months 
Ended September
30, 2008
 
Three Months 
Ended September
30, 2007
 
% change vs.
2007
 
Nine Months 
Ended September
30, 2008
 
Nine Months 
Ended September
30, 2007
 
% change vs.
2007
 
                           
Net loss
   
(2,664,000
)
 
(1,881,000
)
 
42
%
 
(6,182,000
)
 
(4,792,000
)
 
29
%
                                       
Net loss per share, basic and diluted
 
$
(0.19
)
$
(0.14
)
 
36
%
$
(0.45
)
$
(0.35
)
 
29
%
                                       
Weighted average common shares outstanding, basic and diluted
   
14,286,192
   
13,676,030
   
4
%
 
13,879,891
   
13,629,241
   
2
%
 
During the third quarter of 2008, the Company experienced a net loss of $2.7 million, a 42% increase from the net loss of the third quarter of 2007. The increase in net loss during the quarter was primarily the result of the Company’s recognition of a one-time loss on the sale of patent assets of $1.2 million. Otherwise, net loss for the third quarter of 2008 quarter without the impact of this one time loss would have been approximately $1.5 million, a decrease of approximately 20% from the third quarter of 2007. The improvement in net loss, other than the effect of the one-time loss on sale of patent, was due the Company’s ability to increase its sales and gross profits while reducing its operating expenses.
 
LIQUIDITY AND CAPITAL RESOURCES
 
The Company’s cash flows and other key indicators of liquidity are summarized as follows:

21

 
   
As Of And For The Nine Months Ended:
 
   
September 30,
2008
 
September 30,
2007
 
% change vs.
2007
 
               
Cash flows from:
                   
                     
Operating activities
 
$
(2,116,000
)
$
(2,562,000
)
 
17
%
Investing activities
   
(871,000
)
 
(1,495,000
)
 
42
%
Financing activities
   
2,688,000
   
(369,000
)
 
828
%
Working capital
   
(836,000
)
 
352,000
   
-338
%
Current ratio
   
0.68
x  
1.12
 
-39
%
Cash and cash equivalents
 
$
443,000
 
$
1,377,000
   
-68
%
Revolving credit notes
 
$
1,858,000
 
$
-
       
Funds Available from Open Credit Facilities
 
$
1,742,000
 
$
-
       
 
As of September 30, 2008, our cash and cash equivalents were approximately $443,000, down from approximately $742,000 at December 31, 2007. The decrease was primarily due to the use of cash for operations and the use of cash to defend the Company’s patent rights offset by the receipt of $2,358,000 from the Company’s three credit facilities. During the third quarter of 2008, the Company used $500,000 proceeds from the sale and assignment of certain of its patent rights to a third party to pay down one of its credit facilities. As of September 30, 2008, the Company had approximately $1.9 million outstanding under two credit agreements, which are due and payable over the next two years. As of September 30, 2008, the Company was in default of both agreements due to a failure to pay interest when due. Both Fagenson and Co., Inc. and Patrick White have agreed to waive the defaults through January 1, 2010.
 
    
Payment Due by Period
 
   
Total
 
Less than 1
year
 
1-3 years
 
3-5 years
 
More than 5
years
 
Credit Facilities
 
$
1,858,000
 
$
-
 
$
1,858,000
 
$
-
 
$
-
 
 
The Company expects to continue to use cash for its operations and the remainder of 2008. In March 2008, the Company initiated a cost reduction program in order to bring its cash expenditures to a level closer to its current revenue base. As a result of these cost cuts, the Company has reduced its annual cash operating expense base by approximately $1.5 million. In addition, in August 2008, the Company sold 49% of its patent related to its ECB litigation to a third party in exchange for the third party’s commitment to fund nearly all of the remaining costs associated with pending litigation efforts. This agreement, while reducing the potential proceeds that the Company could receive upon a successful outcome of litigation by half, essentially eliminates the Company’s cash requirements for its ECB litigation efforts, which has historically been a significant use of cash for the Company.
 
As of September 30, 2008, the Company has an aggregate of $1,742,000 remaining available under two revolving notes that terminate on January 4, 2010. In addition, the Company has $1,300,000 in subscriptions receivable which it expects to receive in six-month installments over the next two years. Based on these funding sources, the Company believes that it has sufficient available funds to meet is cash needs for the at least the next twelve months.

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ITEM 3:   QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
 
The market risk disclosures as set forth in Item 7A of our Annual Report on Form 10-K for the year ended December 31, 2007 have not changed materially.
 
ITEM 4 - CONTROLS AND PROCEDURES
 
Evaluation of Disclosure Controls and Procedures

Management is responsible for establishing and maintaining effective disclosure controls and procedures. Our Chief Executive Officer and Chief Financial Officer participated with our management in evaluating the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)). Based on this evaluation, and in light of the material weaknesses in our internal control over financial reporting that are discussed in our Annual Report on Form 10-K for the fiscal year ended December 31, 2007 these officers have concluded that our disclosure controls and procedures were not effective. To address the material weaknesses described in Annual Report on Form 10-K for the fiscal year ended December 31, 2007, we performed additional analyses and other post-closing procedures to ensure our consolidated financial statements were prepared in accordance with accounting principles generally accepted in the United States of America (U.S. GAAP). Accordingly, management believes that the financial statements included in this Quarterly Report on Form 10-Q fairly present, in all material respects, our financial condition, result of operations and cash flows for the periods presented.

Changes in Internal Control Over Financial Reporting

During the second quarter of 2008, the Company eliminated the use of an outside consultant formerly used to enhance the segregation of duties for financial reporting. Concurrently, the Company modified and expanded one of its existing internal positions to accommodate some of the control objectives affected by the elimination of the outside consultant role. The Company will evaluate the effect of its changes in internal controls during its annual assessment of its internal controls.
 
 PART II
OTHER INFORMATION
 
ITEM 1 - LEGAL PROCEEDINGS
 
Information concerning pending legal proceedings is incorporated herein by reference to Note 10 to the Condensed Consolidated Financial Statements (Unaudited) in Part I of this Form 10-Q.

On August 1, 2005, we commenced a suit against the European Central Bank (“ECB”) alleging patent infringement by the ECB and claimed unspecified damages. We brought the suit in European Court of First Instance in Luxembourg. We alleged that all Euro banknotes in circulation infringe the Company European Patent 0 455 750B1 (the “Patent”), which covers a method of incorporating an anti-counterfeiting feature into banknotes or similar security documents to protect against forgeries by digital scanning and copying devices. The Court of First Instance ruled on September 5, 2007 that it does not have jurisdiction to rule on the patent infringement claim, and also ruled that we will be required to pay attorneys and court fees of the ECB. The ECB formally requested the Company to pay attorneys and court fees in the amount of Euro 93,752 ($144,000), which, unless the amount is agreed will be subject to an assessment procedure that will not likely be concluded until approximately the end of 2008, which the Company will accrue as soon as the assessed amount, if any, is estimatable.

On March 24, 2006, we received notice that the ECB has filed a separate claim in the United Kingdom and Luxembourg courts seeking the invalidation of the Patent. Proceedings were commenced before the national courts seeking revocation and declarations of invalidity of the Patent in each of the Netherlands, Belgium, Italy, France, Spain, Germany and Austria. On March 26, 2007, the High Court of Justice, Chancery Division, Patents Court in London, England (the “English Court”) ruled that the Patent was deemed invalid in the United Kingdom, and on March 19, 2008 this decision was upheld on appeal. The English Court rejected the ECB’s allegations of invalidity based on lack of novelty, lack of inventive step and insufficiency, but held that the patent was invalid for added subject matter. The English Court’s decision does not affect the validity of the Patent in other European countries. On March 30, 2007, the English Court awarded the ECB 30% of their costs (including legal fees) of the initial trial, of which the Company paid 90,000 British pounds ($182,000) on April 19, 2007. We expect that an additional 90,000 pounds ($162,000 at September 30, 2008) will become payable by the Company for the costs of the initial trial, which is included in accrued expenses as of September 30, 2008. In July 2007, the Company posted a bond of 87,500 British pounds ($157,500 at September 30, 2008), as collateral for the appeal costs which is recorded as restricted cash at September 30, 2008. On June 19, 2008, the Company paid 87,500 British pounds ($177,000 based on the applicable exchange rate on that date) towards the ECB’s costs of the English appeal. The Company may also owe additional legal fees associated with the Court of Appeal decisions, which, unless otherwise agreed by the parties, will be subject to an assessment procedure that will not likely be concluded earlier than the first quarter of 2009. The Company will record the assessed amount, if any, as soon as it is estimatable.

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On March 27, 2007 the Bundespatentgericht of the Federal Republic of Germany ruled that the German part of the Patent was valid, having considered the English Court’s decision. As a result of this ruling, the Company expects to be awarded reimbursements for its costs associated with the German validity case, which is Euro 44,692 ($64,000 at September 30, 2008), which the Company will record when the amount, if any, is received. The ECB has filed an appeal against that decision, which is not expected to be decided before 2010. On January 9, 2008 the French Court held that the Patent was invalid in France for the same reasons given by the English Court. The Company is required to pay de minimus attorneys’ fees of the ECB as a result of the French decision. The Company filed an appeal against the French decision on May 7, 2008. On March 12, 2008 the Dutch Court, having considered the English, German and French decisions, ruled that the Patent is valid in the Netherlands. The ECB filed an appeal against the Dutch decision on March 27, 2008. A trial was also held in Madrid, Spain on June 3 and 5, 2008 and oral and written closing submissions were made on July 19, 2008. A judgment is expected in the fourth quarter of 2008.
 
The Patent has thus been confirmed to be valid and enforceable in two jurisdictions (Germany and the Netherlands) that use the Euro as its national currency. Additional trials on the validity of the Patent are expected in other European jurisdictions in 2008 and 2009.

On August 20, 2008, the Company entered into an agreement with Trebuchet Capital Partners, LLC (“Trebuchet”) under which Trebuchet has agreed to pay substantially all of the litigation costs associated with pending validity proceedings initiated by the European Central Bank (“ECB”) in eight European countries relating to the Company’s European Patent 0 455 750B1 that the Company has claimed the ECB infringed in printing of the Euro currency (the “Patent”). Trebuchet also agreed to pay substantially all of the litigation costs associated with future validity challenges filed by the ECB or other parties, provided that Trebuchet elects to assume the defense of any such challenges, in its sole discretion, and patent infringement suits filed against the ECB and certain other alleged infringers of the Patent, all of which suits may be brought at the sole discretion of Trebuchet and may be in the name of the Company, Trebuchet or both. The Company provided Trebuchet with the sole and exclusive right to manage infringement litigation relating to the Patent in Europe, including the right to initiate litigation in the name of the Company, Trebuchet or both and to choose whom and where to sue, subject to certain limitations set forth in the agreement. Under the terms of the Agreement, the Company and Trebuchet have agreed to equally share all proceeds generated from litigation relating to the Patent, including judgments and licenses or other arrangements entered into in settlement of any such litigation. Trebuchet is also entitled to recoup any litigation expenses specifically awarded to the Company in such actions.

On January 31, 2003, the Company commenced an action, unrelated to the above ECB litigation, entitled New Sky Communications, Inc., As Successor-In-Interest To Thomas M. Wicker, Thomas M.Wicker Enterprises, Inc. and Document Security Consultants V. Adler Technologies, Inc. N/K/A Adlertech International, Inc. and Andrew McTaggert (United States District Court, Western District Of New York Case No.03-Cv-6044t(F)) regarding certain intellectual property in which the Company have an interest. The Company commenced this action alleging various causes of action against Adler Technologies, Inc. and Andrew McTaggert for breach of contract, breach of the duty of good faith and fair dealing, various business torts, including unfair competition and declaratory relief. Adler distributes and supplies anti-counterfeit document products and Mr. McTaggert is a principal of Adler. Adler had entered into several purported agreements with Thomas M. Wicker Enterprises and Document Security Consultants, both of which the Company acquired in 2002. These alleged agreements, generally, would have authorized Adler to manufacture in Canada the Company’s “Checkmate®” patented system for verifying the authenticity of currency and documents. Other purported agreements were signed between these parties and Thomas Wicker regarding other technology claimed to have been owned by Wicker and assigned to the Company. Among other things, the Company contends that certain of the purported agreements are not binding and/or enforceable. To the extent any of them are binding and enforceable, the Company claims that Adler has breached these purported agreements, failed to make an appropriate accounting and payments under them, and may have exceeded the scope of its license. Adler has denied the material allegations of the complaint and has counterclaimed against the Company, claiming Adler owns or co-owns or has a license to use certain of the Company’s technologies. In May 2005, the Company filed a first amended and supplemental complaint adding Blanks/USA and Raymond Maxon as additional defendants. In February 2007, the Company filed a second amended and supplemental complaint adding Judith Wu (McTaggert’s wife) and Arcis Digital Security, Inc. (a company in which Ms. Wu is involved) as additional defendants. Maxon has asserted a counterclaim against the Company contending that the Company’s purported acquisition of a certain patent from Thomas Wicker in 2002 gave rise to an alleged right on the part of Maxon to receive a portion of Thomas Wicker’s proceeds from such acquisition. The Company has denied the material allegations of all of the counterclaims. If Adler or Maxon is successful, it may materially affect the Company, the Company’s financial condition, and the Company’s ability to market and sell certain of the Company technology and related products. This case is in discovery phase, and it is too soon to determine how the various issues raised by the lawsuit will be determined.

In addition to the foregoing, we are subject to other legal proceedings that have arisen in the ordinary course of business and have not been finally adjudicated. Although there can be no assurance in this regard, in the opinion of management, none of these legal proceedings to which we are a party will have a material adverse effect on our results of operations, cash flows or our financial condition.

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ITEM 1A – RISK FACTORS
 
An investment in our securities is subject to numerous risks, including the Risk Factors described below. Our business, operating results or financial condition could be materially adversely affected by any of the following risks. The risks described below are not the only ones we face. Additional risks we are not presently aware of or that we currently believe are immaterial may also materially affect our business. The trading price of our Common Stock could decline due to any of these risks. In assessing these risks, you should also refer to the other information contained or incorporated by reference in this Form 10-Q, including our financial statements and related notes and information contained in our Form 10-K for the year ended December 31, 2007.

We have a limited operating history with our business model, which limits the information available to you to evaluate our business.
 
Since our inception in 1984, we have accumulated deficits from historical operations of approximately $30,397,000 at September 30, 2008. In 2002, we changed our business model and chose to strategically focus on becoming a developer and marketer of secure technologies for all forms of print media. We have continued to incur losses since we began our new business model. Also, we have limited operating and financial information relating to this new business to evaluate our performance and future prospects. Due to the change in our business model, we do not view our historical financials as being a good indication of our future. We face the risks and difficulties of a company going into a new business including the uncertainties of market acceptance, competition, cost increases and delays in achieving business objectives. There can be no assurance that we will succeed in addressing any or all of these risks, and the failure to do so could have a material adverse effect on our business, financial condition and operating results.

We have secured credit facilities that have large principal payments due and if we are unable to repay them with cash we may be forced to repay, in whole on in part, with each credit facility’s applicable collateral, which would have a material adverse effect on our financial position.
 
On January 4, 2008, we entered into two credit facilities with and aggregate borrowing capacity of $3.6 million that is repayable in full on January 4, 2010. One of these credit facilities has a borrowing limit of $3.0 million and is secured by our stock in our Plastic Printing Professionals, Inc. subsidiary (“P3”), and the other credit facility has a borrowing limit of $600,000 and is secured by our accounts receivable, excluding the accounts receivable of P3. As of September 30, 2008, the Company was in default of both agreements due to a failure to pay interest when due. Both Fagenson and Co., Inc. and Patrick White have agreed to waive the default through January 1, 2010. If we cannot generate sufficient cash from operations or raise cash from other sources, including without limitation, fund-raising through sales of equity, and if we cannot refinance the credit facilities, we may have to repay, in whole or in part, one or both of the credit facilities with each credit facility’s applicable collateral, which would have a material adverse effect on our financial position.

Due to our low cash balance and negative cash flow, we may have to further reduce our costs by curtailing future operations.

We have incurred significant net losses this year and previous years. Our ability to fund our capital requirements out of our available cash and cash generated from our operations depends on a number of factors. Some of these factors include our ability to (i) increase paper and plastic card sales and (ii) increase sales of our digital products. If we cannot generate positive cash flow from operations, we will have to continue to reduce our costs and raise working capital from other sources. These measures could include selling or consolidating certain operations or assets, and delaying, canceling or scaling back product development and marketing programs. These measures could materially and adversely affect our ability to operate profitably.

Our ability to effect a financing transaction to fund our operations could adversely affect the value of your stock.

If we seek additional financing through raising additional capital through public or private equity offerings or debt financing, such additional capital financing may not be available to us on favorable terms and our stockholders will likely experience substantial dilution. Material shortage of capital will require us to take steps such as reducing our level of operations, disposing of selected assets, effecting financings on less than favorable terms or seeking protection under federal bankruptcy laws.

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Our limited cash resources may not be sufficient to fund continuing losses from operations and the expenses of the current patent validity and patent infringement litigations.

The cost to defend and prosecute current and future patent litigation may be significant. We cannot assure you that the ultimate cost of current known or future unknown litigation and claims will not exceed our current expectations and/or our ability to pay such costs and it is possible that such litigation costs could have a material adverse effect on our business, financial condition and operating results. In addition, litigation is time consuming and could divert management attention and resources away from our business, which could adversely affect our business, financial condition and operating results.

If we lose our current litigation, we may lose certain of our technology rights, which may affect our business plan.
  
We are subject to litigation and alleged litigation, including without limitation our litigation with the European Central Bank, in which parties allege, among other things, that certain of our patents are invalid. For more information regarding this litigation, see Part II Item 1- Legal Proceedings. If the ECB or other parties are successful in invalidating any or all of our patents, it may materially affect us, our financial condition, and our ability to market and sell certain of our products based on any patent that is invalidated. Furthermore, we have granted nearly all control over our ECB Litigation a third party, Trebuchet Capital Partners, LLC., who may or may not have the resources or capabilities to successfully defend our patent rights.

If we lose our current validity or infringement litigation we may be liable for significant legal costs of our counterparts.
 
We have been able to mitigate the cash outlays that we have been required to make for legal costs of our current invalidity cases against the European Central Bank by, among other things, negotiating legal fee caps and using shares of our common stock for payments. However, if we receive adverse rulings in any of our infringement or related invalidity cases against the European Central Bank, we will likely be responsible for a large portion of the legal costs that were expended by the European Central Bank in such case, which would likely be significant, with our current estimates of between $1,000,000 to $2,000,000. The payment of these amounts could have a material adverse impact on our operations, cash available and liquidity.
 
If we are unable to adequately protect our intellectual property, our competitive advantage may disappear.
 
Our success will be determined in part by our ability to obtain United States and foreign patent protection for our technology and to preserve our trade secrets. Because of the substantial length of time and expense associated with developing new document security technology, we place considerable importance on patent and trade secret protection. We intend to continue to rely primarily on a combination of patent protection, trade secrets, technical measures, copyright protection and nondisclosure agreements with our employees and customers to establish and protect the ideas, concepts and documentation of software and trade secrets developed by us. Our ability to compete and the ability of our business to grow could suffer if these intellectual property rights are not adequately protected. There can be no assurance that our patent applications will result in patents being issued or that current or additional patents will afford protection against competitors. We rely on a combination of patents, copyrights, trademarks and trade secret protection and contractual rights to establish and protect our intellectual property. Failure of our patents, copyrights, trademarks and trade secret protection, non-disclosure agreements and other measures to provide protection of our technology and our intellectual property rights could enable our competitors to more effectively compete with us and have an adverse effect on our business, financial condition and results of operations. In addition, our trade secrets and proprietary know-how may otherwise become known or be independently discovered by others. No guarantee can be given that others will not independently develop substantially equivalent proprietary information or techniques, or otherwise gain access to our proprietary technology.

In addition, we may be required to litigate in the future to enforce our intellectual property rights, to protect our trade secrets, to determine the validity and scope of the proprietary rights of others, or to defend against claims of infringement or invalidity. Any such litigation could result in substantial costs and diversion of resources and could have a material adverse effect on our business, financial condition or results of operations, and there can be no assurances of the success of any such litigation.

We may face intellectual property infringement or other claims against us, our customers or our intellectual property that could be costly to defend and result in our loss of significant rights.

Although we have received or applied for U.S., European and International Patents with respect to certain technologies of ours, there can be no assurance that these patents will afford us any meaningful protection. Although we believe that our use of the technology and products we developed and other trade secrets used in our operations do not infringe upon the rights of others, our use of the technology and trade secrets we developed may infringe upon the patents or intellectual property rights of others. In the event of infringement, we could, under certain circumstances, be required to obtain a license or modify aspects of the technology and trade secrets we developed or refrain from using same. We may not have the necessary financial resources to defend an infringement claim made against us or be able to successfully terminate any infringement in a timely manner, upon acceptable terms and conditions or at all. Failure to do any of the foregoing could have a material adverse effect on us and our financial condition. Moreover, if the patents, technology or trade secrets we developed or use in our business are deemed to infringe upon the rights of others, we could, under certain circumstances, become liable for damages, which could have a material adverse effect on us and our financial condition. As we continue to market our products, we could encounter patent barriers that are not known today. A patent search will not disclose applications that are currently pending in the United States Patent Office, and there may be one or more such pending applications that would take precedence over any or all of our applications.

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Furthermore, third parties may assert that our intellectual property rights are invalid, which could result in significant expenditures by us to refute such assertions. If we become involved in litigation, we could lose our proprietary rights, be subject to damages and incur substantial unexpected operating expenses. Intellectual property litigation is expensive and time-consuming, even if the claims are subsequently proven unfounded, and could divert management’s attention from our business. If there is a successful claim of infringement, we may not be able to develop non-infringing technology or enter into royalty or license agreements on acceptable terms, if at all. If we are unsuccessful in defending claims that our intellectual property rights are invalid, we may not be able to enter into royalty or license agreements on acceptable terms, if at all. This could prohibit us from providing our products and services to customers, which could have a material adverse effect on us and our financial condition.

If our products and services do not achieve market acceptance, we may not achieve our revenue and net income goals in the time prescribed or at all.

We are at the early stage of introducing our document security technology and products to the market. If we are unable to operate our business as contemplated by our business model or if the assumptions underlying our business model prove to be unfounded, we could fail to achieve our revenue and net income goals within the time we have projected, or at all, which could have a material adverse effect on our business. As a result, the value of your investment could be significantly reduced or completely lost.

We cannot assure you that a sufficient number of companies will purchase our products or services or other document security products. In addition, we cannot predict the rate of market’s acceptance of our document security solutions. Failure to maintain a significant customer base may have a material adverse effect on our business.

Certain of our recently developed products are not yet commercially accepted and there can be no assurance that those products will be accepted, which would adversely affect our financial results.

Over the past one to two years, we have spent significant funds and time to create new products by applying our technologies onto media other than paper, including plastic and cardboard packaging, and delivered our technologies digitally. We have had limited success in selling our products that are on cardboard packaging and those that are delivered digitally. If we are not able to successfully sell these new products, our financial results will be adversely affected.

The results of our research and development efforts are uncertain and there can be no assurance of the commercial success of our products.

We believe that we will need to continue to incur research and development expenditures to remain competitive. The products we currently are developing or may develop in the future may not be technologically successful. In addition, the length of our product development cycle may be greater than we originally expect and we may experience delays in future product development. If our resulting products are not technologically successful, they may not achieve market acceptance or compete effectively with our competitors’ products.

Changes in document security technology and standards could render our applications and services obsolete.

The market for document security products, applications, and services is fast moving and evolving. Identification and authentication technology is constantly changing as we and our competitors introduce new products, applications, and services, and retire old ones as customer requirements quickly develop and change. In addition, the standards for document security are continuing to evolve. If any segments of our market adopt technologies or standards that are inconsistent with our applications and technology, sales to those market segments could decline, which could have a material adverse effect on us and our financial condition.

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The market in which we operate is highly competitive, and we may not be able to compete effectively, especially against established industry competitors with greater market presence and financial resources.

Our market is highly competitive and characterized by rapid technological change and product innovations. Our competitors may have advantages over us because of their longer operating histories, more established products, greater name recognition, larger customer bases, and greater financial, technical and marketing resources. As a result, they may be able to adapt more quickly to new or emerging technologies and changes in customer requirements, and devote greater resources to the promotion and sale of their products. Competition may also force us to decrease the price of our products and services. We cannot assure you that we will be successful in developing and introducing new technology on a timely basis, new products with enhanced features, or that these products, if introduced, will enable us to establish selling prices and gross margins at profitable levels.

Our growth strategy depends, in part, on our acquiring complementary businesses and assets and expanding our existing operations to include manufacturing capabilities, which we may be unable to do.

Our growth strategy is based, in part, on our ability to acquire businesses and assets that are complimentary to our existing operations and expanding our operations to include manufacturing capabilities. We may also seek to acquire other businesses. The success of this acquisition strategy will depend, in part, on our ability to accomplish the following:

 
·
identify suitable businesses or assets to buy;
 
·
complete the purchase of those businesses on terms acceptable to us;
 
·
complete the acquisition in the time frame we expect; and
 
·
improve the results of operations of the businesses that we buy and successfully integrate their operations into our own.

Although we were able to successfully acquire our Plastic Printing Professionals, Inc. subsidiary in February 2006, there can be no assurance that we will be successful in pursuing any or all of these steps on future transactions. Our failure to implement our acquisition strategy could have an adverse effect on other aspects of our business strategy and our business in general. We may not be able to find appropriate acquisition candidates, acquire those candidates that we find or integrate acquired businesses effectively or profitably.

Our acquisition program and strategy may lead us to contemplate acquisitions of companies in bankruptcy, which entail additional risks and uncertainties. Such risks and uncertainties include, without limitation, that, before assets may be acquired, customers may leave in search of more stable providers and vendors may terminate key relationships. Also, assets are generally acquired on an “as is” basis, with no recourse to the seller if the assets are not as valuable as may be represented. Finally, while bankrupt companies may be acquired for comparatively little money, the cost of continuing the operations may significantly exceed expectations.

We have in the past used, and may continue to use, our Common Stock as payment for all or a portion of the purchase price for acquisitions. If we issue significant amounts of our Common Stock for such acquisitions, this could result in substantial dilution of the equity interests of our stockholders.

If we fail to retain our key personnel and attract and retain additional qualified personnel, we might not be able to pursue our growth strategy.

Our future success depends upon the continued service of our executive officers and other key sales and research personnel who possess longstanding industry relationships and technical knowledge of our products and operations. The loss of any of our key employees, in particular, Patrick White, our Chief Executive Officer and David Wicker, our Vice-President of Operations, could negatively impact our ability to pursue our growth strategy and conduct operations. Although we believe that our relationship with these individuals is positive, there can be no assurance that the services of these individuals will continue to be available to us in the future. We have extended our employment agreements with Patrick White to June 2009. Our employment agreement with David Wicker expires in June 2009. There can be no assurance that these persons will continue to agree to be employed by us after such dates.

Future growth in our business could make it difficult to manage our resources.

Our anticipated business expansion could place a significant strain on our management, administrative and financial resources. Significant growth in our business may require us to implement additional operating, product development and financial controls, improve coordination among marketing, product development and finance functions, increase capital expenditures and hire additional personnel. There can be no assurance that we will be able to successfully manage any substantial expansion of our business, including attracting and retaining qualified personnel. Any failure to properly manage our future growth could negatively impact our business and operating results.

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We cannot predict our future capital needs and we may not be able to secure additional financing.

We may need to raise additional funds in the future to fund more aggressive expansion of our business, complete the development, testing and marketing of our products, or make strategic acquisitions or investments. We may require additional equity or debt financings, collaborative arrangements with corporate partners or funds from other sources for these purposes. No assurance can be given that these funds will be available for us to finance our development on acceptable terms, if at all. Such additional financings may involve substantial dilution of our stockholders or may require that we relinquish rights to certain of our technologies or products. In addition, we may experience operational difficulties and delays due to working capital restrictions. If adequate funds are not available from operations or additional sources of financing, we may have to delay or scale back our growth plans. In June 2008, we sold 350,000 shares for an aggregate purchase price of $1.4 million, with $100,000 payable at closing and the remaining $1.3 million payable in six-month installments over two years. If the Purchaser of such 350,000 does not pay some or all of such remaining $1.3 million purchase price, we will have limited, if any, recourse against the purchaser other than recouping a pro-rata amount of the 350,000 shares. If we do not receive the remaining $1.3 million of the purchase price on schedule, our financial position and financing resources may be materially adversely affected.

Risks Related to Our Stock

Provisions of our certificate of incorporation and agreements could delay or prevent a change in control of our company.

Certain provisions of our certificate of incorporation may discourage, delay, or prevent a merger or acquisition that a stockholder may consider favorable. These provisions include:

 
·
the authority of the Board of Directors to issue preferred stock; and
 
·
a prohibition on cumulative voting in the election of directors.

We have a large number of authorized but unissued shares of common stock, which our management may issue without further stockholder approval, thereby causing dilution of your holdings of our common stock.

As of September 30, 2008, there are approximately 185 million shares of authorized but unissued shares of our common stock. Our management will continue to have broad discretion to issue shares of our common stock in a range of transactions, including capital-raising transactions, mergers, acquisitions, for anti-takeover purposes, and in other transactions, without obtaining stockholder approval, unless stockholder approval is required for a particular transaction under the rules of the American Stock Exchange, New York law, or other applicable laws. We currently have no specific plans to issue shares of our common stock for any purpose. However, if our management determines to issue shares of our common stock from the large pool of such authorized but unissued shares for any purpose in the future without obtaining stockholder approval, your ownership position would be diluted without your further ability to vote on that transaction.

The exercise of our outstanding options and warrants and vesting of restricted stock awards may depress our stock price.

As of September 30, 2008, there were outstanding stock options and warrants to purchase an aggregate of 1,306,343 shares of our Common Stock at exercise prices ranging from $2.20 to $12.65 per share and a weighted average exercise price of $10.24. In addition, as of September 30, 2008, there were 237,793 restricted shares of our common stock that are subject to various vesting terms. To the extent that these securities vest, dilution to our stockholders will occur. Moreover, the terms upon which we will be able to obtain additional equity capital may be adversely affected, since the holders of these securities can be expected to exercise or convert them at a time when we would, in all likelihood, be able to obtain any needed capital on terms more favorable to us than the exercise and conversion terms provided by those securities.

Sales of these shares in the public market, or the perception that future sales of these shares could occur, could have the effect of lowering the market price of our common stock below current levels and make it more difficult for us and our stockholders to sell our equity securities in the future.

Sale or the availability for sale of shares of common stock by stockholders could cause the market price of our common stock to decline and could impair our ability to raise capital through an offering of additional equity securities.

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We do not intend to pay cash dividends.

We do not intend to declare or pay cash dividends on our common stock in the foreseeable future. We anticipate that we will retain any earnings and other cash resources for investment in our business. The payment of dividends on our common stock is subject to the discretion of our Board of Directors and will depend on our operations, financial position, financial requirements, general business conditions, restrictions imposed by financing arrangements, if any, legal restrictions on the payment of dividends and other factors that our Board of Directors deems relevant.
 
ITEM 2 - UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
 
On August 20, 2008, the Company entered into an agreement with Trebuchet Capital Partners, LLC which agreed to pay substantially all of the litigation costs associated with pending validity proceedings initiated by the ECB in eight European countries relating to the Company’s European Patent 0 455 750B1 that the Company has claimed the ECB infringed in printing of the Euro currency. Trebuchet has also purchased 100,000 shares of the Company’s common stock, subject to the American Stock Exchange approving the listing of such shares, for an aggregate purchase price of $400,000, the proceeds of which will be used by the Company to pay existing, accrued costs related to the Litigation. On July 18, 2008, the Company issued 19,266 shares to a vendor as payment for $94,000 of the vendor’s outstanding bills.
 
ITEM 3 - DEFAULTS UPON SENIOR SECURITIES
 
On January 4, 2008, the Company entered into a Credit Facility Agreement with Fagenson and Co., Inc., as agent, a related party to Robert B. Fagenson, the Chairman of the Company's Board of Directors. Under the Fagenson Credit Agreement, the Company can borrow up to a maximum of $3,000,000 from time to time up to and until January 4, 2010. The advances are generally limited to $400,000 unless otherwise mutually agreed upon by both parties per fiscal quarter, with the exception of $600,000 that can be advanced at any time for patent litigation related bills. Any amount borrowed by the Company pursuant to the Fagenson Credit Agreement will have an annual interest rate of 2% above LIBOR and will be secured by the Common Stock of Plastic Printing Professionals, Inc., (“P3”) the Company's wholly owned subsidiary. Interest is payable quarterly in arrears and the principal is payable in full at the end of the term under the Fagenson Credit Agreement. In addition, on January 4, 2008, the Company also entered into a Credit Facility Agreement with Patrick White, the Company's Chief Executive Officer and a member of the Board of Directors. Under the White Credit Agreement, the Company can borrow up to $600,000 from time to time up to and until January 4, 2010. Any amount borrowed by the Company pursuant to the White Credit Agreement will have an annual interest rate of 2% above LIBOR and will be secured by the accounts receivable of the Company, excluding the accounts receivable of P3. Interest is payable quarterly in arrears and the principal is payable in full at the end of the Term under the White Credit Agreement. Mr. White can accept common stock as repayment of the loan upon a default. Under the terms of the agreement the Company is required to comply with various covenants. During the year ended December 31, 2007, Patrick White advanced the Company $300,000 while the terms of the credit facility were being finalized. As of September 30, 2008, the Company was in default of both agreements due to a failure to pay interest when due. Both Fagenson and Co., Inc. and Patrick White have agreed to waive the default through January 1, 2010.
 
ITEM 4 - SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS 
 
None 
 
ITEM 5 - OTHER INFORMATION
 
None       

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ITEM 6 - EXHIBITS
 
The Exhibits listed below designated by an * are incorporated by reference to the filings by Document Security Systems, Inc. under the Securities Act of 1933 or the Securities and Exchange Act of 1934, as indicated. All other exhibits are filed herewith.
 
  (a)   Exhibits
 
Item 3.1  Articles of Organization of the Registrant, as amended (incorporated by reference to exhibit 3.1 to the Company's Registration Statements No. 2-98684-NY on Form S-18).*
 
Item 3.2  By-laws of the Registrant, as amended (incorporation by reference to exhibit 3.2 to the Company's Registration Statement No. 2-98684-NY on Form S-18).*
 
Item 10.1 Agreement, dated August 20, 2008, between Document Security Systems, Inc. and Trebuchet Capital Partners, LLC

Item 31.1  Certifications of Chief Executive Officer Pursuant to Section 302 of the Sarbanes Oxley Act
 
Item 31.2  Certifications of Acting Chief Financial Officer Pursuant to Section 302 of the Sarbanes Oxley Act

Item 32.1 Certification of Chief Executive Officer Pursuant to Section 906 of the Sarbanes Oxley Act

Item 32.2 Certification of Acting Chief Financial Officer Pursuant to Section 906 of the Sarbanes Oxley Act
 
SIGNATURES
 
            In accordance with the requirements of the Exchange Act, the registrant caused this report on Form 10-Q to be signed on its behalf by the undersigned, thereunto duly authorized.
 
 
 
 
 
DOCUMENT SECURITY SYSTEMS, INC.
 
 
 
 
 
 
 
 
November 10, 2008
 
By: 
/s/ Patrick White
 
 
 
 
 
Patrick White
Chief Executive Officer
 
 
 
 
 
   
 
 
 
 
 
 
 
November 10, 2008
 
By: 
/s/ Philip Jones
 
       
Philip Jones
 
       
Acting Chief Financial Officer
(Vice President of Finance)
 
 
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